Gold Prices

By Haubrich, Joseph G. | Economic Commentary (Cleveland), March 1, 1998 | Go to article overview

Gold Prices


Haubrich, Joseph G., Economic Commentary (Cleveland)


This January marked the 150th anniversary of a major event in Amencan history: the discovery of gold at Sutter's Mill, California. Fittingly, gold made news again this year by dropping past $300 an ounce to hit its lowest price in nearly two decades. While some of the subject's interest undoubtedly springs from an almost voyeuristic fascination with the precious metal itself, gold prices are nonetheless legitimate news, since they are considered harbingers of stability or future inflation. Careful observers' acquaintance with the gold market's particular twists, turns, and idiosyncrasies gives them a more reasoned understanding of its uses as an economic indicator. This Economic Commentary takes the confluence of historical and current events as an excuse to refine our understanding of gold, gold prices, and inflation.

Supply and Demand

Like any other good, gold's price depends on supply and demand. But unlike wheat, say, where most of the current supply comes from this year's crop, gold is storable and most of the supply comes from past production accumulated over centuries. In economists' jargon, the current stock far exceeds this year's flow. Of the total world supply of 125,000 metric tons of gold, annual production ranges around 2,400 tons. This means that in contrast to soybeans, corn, or pork bellies, this year's gold production has little influence on prices.

In this sense, gold behaves less like a commodity than like long-lived assets such as stocks or bonds. That characteristic makes expectations particularly important because, like the stock market, gold prices are forward-looking, and today's price depends heavily on future demand and supply.

Among other things, these expectations must take account of uncertainties in gold production, the most obvious being discoveries of new deposits. Production increased dramatically after discovery of the New World (which provided some exceptionally low-cost mines, such as Inca temples and palaces), and again in the 1850s when California and Australia became important producers. Equally essential, though less romanticized by Hollywood, have been technological changes. Development of the cyanide extraction process in 1890, for example, made it possible to recover gold from an inferior grade of ore. Further developments in chemistry and engineering continue to lower the price of extraction.

Still, unlike stocks, bonds, or Rembrandts, gold production does depend on prices. If the price of gold is very high, more mines will open up and existing ones will take out lower-grade ore. If the price is very low, some mines will shut down and others will curtail production, leaving low-grade ore in the ground. This adds a degree of "mean reversion" to the price of gold, which tends slowly to return to the cost of producing more gold.

In the very short term, however, there may be no such mean reversion. A price increase today could signal an even bigger rise in the near future, enticing mine operators to reduce output until prices move up. Alternatively, high prices may reduce output temporarily by encouraging some mine operators to move to low-grade ore, which is only profitable when prices are high. Since production capacity can be somewhat fixed, the shift to lower-grade ore could mean a lower supply-and thus a higher price-of gold.1

Gold demand puts its own spin on matters. Unlike oil, for example, which literally goes up in smoke, gold is rarely destroyed while being used.2 The largest demand is for jewelry and investments (which are often lumped together because it's hard to categorize Krugerrand cuff links or ingot necklaces). Combined jewelry and investment demand runs about 2,800 tons a year. Dental and industrial demand is smaller, at 120 tons annually. Gold, of all known metals the most malleable (easily shaped) and ductile (easily hammered flat or pulled into a wire),3 has many industrial applications. Fine wires are used in electronics: thin coatings are used to insulate glass. …

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