Golden Reality Check: The Illusion of 2% Inflation

Gold prices remain under pressure, but its ability to hold critical support levels reveals that investors could be worried that hawkish monetary policies worldwide have run their course, even as inflation remains stubbornly high.

Although the U.S. Federal Reserve has maintained its hawkish bias, there are signs that the European Central Bank could be ready to shift to a more neutral stance on monetary policy and potentially adjust its inflation target rate, according to Chantelle Schieven, head of research at Capitalight Research.

Schieven's comments come ahead of the ECB's monetary policy decision Thursday. The central bank is expected to leave interest rates at 4.75%. Many economists have said it could be difficult for the ECB to continue raising interest rates as the regional economy continues to slow.

Last month, during the Federal Reserve's central bank symposium at Jackson Hole, Wyoming, ECB President Christine Lagarde said that the world could be seeing the start of a new economic era.

"We may be entering an age of shifts in economic relationships and breaks in established regularities. For policymakers with a stability mandate, this poses a significant challenge­," she said in her prepared remarks. "We must and we will keep inflation at 2% over the medium term. But in order to achieve our goals, we need flexibility in our analysis. We cannot make policy based on simple rules or intermediate targets in an uncertain economy. And this means that we cannot exclusively rely on models that are estimated with old data, attempting to fine-tune policy around point forecasts."

Schieven said that while the central bank isn't expecting to make any significant policy announcements this week, the ECB could be laying the groundwork as inflation is expected to remain stubbornly elevated.

Schieven added that it is difficult to see how inflation falls as commodity markets continue to see broad supply constraints, keeping food and basic material prices elevated. The oil market is seen as a prime example as OPEC+ supply cuts continue to support prices near their highest levels in a near.

"I don't think we will see a major recession in the next quarter or two, but the global economy continues to weaken," she said. "At some point, central banks like the ECB and the Federal Reserve will have to choose between supporting their economies or keeping inflation under control. I don't think they can do both."

Along with elevated commodity prices, Schieven said it will be difficult for central banks to get inflation under control as sovereign debts continue to rise. The U.S. is expected to see its deficit grow by $2 trillion this year, roughly doubling last year's increase.

Schieven said that this environment supports gold as higher inflation will keep real bond yields and the U.S. dollar in check.

"I don't think we are entering an era of hyperinflation, but headline inflation above 3% or 4% during the next couple of years is not unreasonable," she said.

Although the Federal Reserve has been clear that it is not prepared to adjust its inflation target, Schieven said that investors should remember that there are no absolutes within the financial sector. She pointed out that the U.S. central bank spent a year trying to convince markets that inflation was only transitory before embarking on the most aggressive tightening cycle on record.

Schieven said the labor market will be the key to the Federal Reserve's monetary policy. Although the U.S. labor market has been relatively resilient, there are signs of cooling.

"When we start to see significant weakness in the labor market, I think that will prompt the Federal Reserve to focus on the second part of their dual mandate of full employment and price stability," she said.

While gold investors will have to remain patient as the market remains stuck in neutral, Schieven said that she still sees potential for prices to move back to $2,000 an ounce.

"Investors might have to wait until the second quarter of next year before gold really gets going. We have almost $2,100 priced in by the end of next year. We expect the Fed will be reducing by the end of next year," said Schieven.

Although investors need to be a little more patient, Schieven said that given the precious metal's resilience this past year, it won't take much to ignite a rally to new all-time highs.

"Given how strong the U.S. dollar has been and how high bond yields are, gold prices should be $100 to $200 lower. The fact that prices are not lower shows just how much demand there is in the marketplace," she said.

Originally published by Neils Christensen at Kitco