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Why Gold Investors Should Love Central Banks

Written By Geoffrey Pike

Posted March 15, 2016

eucentral 600x399After the European Central Bank (ECB) announced new rounds of monetary stimulus last week, gold initially surged upward on the news. It did fall back down on Friday, but there is little question that gold prices were reacting to the news of European monetary policy.

The ECB cut its key interest rate to zero, while going further into negative territory on its bank deposit rate. The deposit rate now stands at -0.4%, meaning that banks will be charged this amount for their deposits held at the central bank.

This policy is supposed to encourage banks to lend out deposits to businesses and individuals, instead of holding it as reserves with the central bank. The theory is that banks would rather lend out the money instead of being charged for holding on to the money.

One of the problems (from the ECB’s perspective) is that many people and businesses do not want to borrow money, even at really low rates. And banks don’t want to necessarily lend money to risky borrowers. It may be preferable to take a 0.4% loss rather than a bigger loss due to default.

The other major announcement by the ECB is that it was upping the ante on its so-called quantitative easing (QE) program. It will now buy 80 billion euros per month in assets. Whereas before the ECB was only buying eurozone bonds from financial institutions, the ECB will now also buy bonds issued by companies.

We couldn’t possibly see any favoritism or cronyism resulting from this policy (note the sarcasm).

The ECB’s 80 billion euros per month is equal to about $89 billion. This is slightly more than the Federal Reserve’s $85 billion per month that it was buying at the peak of QE3 in 2013. In other words, this is massive monetary stimulus.

We say that the central bank is buying assets, but it is buying these assets by creating digits on a computer screen. This is money creation, pure and simple.

The ECB, along with the other major central banks of the world, are trying desperately to increase price inflation. They just can’t stand an environment of price stability or even slight price deflation. We can’t stand for people paying less for goods and services.

The funny thing is that the actions of the ECB and other central banks (excluding the Fed right now) are just creating more panic because of their policies. It just makes the public more fearful and even less inclined to spend their money.

Still, at some point, the ECB – or any central bank – can create positive price inflation with enough monetary inflation. It can happen quickly too.

Gold’s Reaction

It is interesting that gold initially went up on this news. It is also interesting that gold has been doing well in 2016, despite talk of an economic downturn, or even a global recession.

Perhaps gold investors were anticipating that with a weak economy, the central banks of the world would become even more aggressive with their monetary stimulus, which would be favorable to gold. And perhaps the gold buyers of the last couple of months were on to something.

One question that remains right now is whether gold is going up because of negative interest rates, or because of monetary inflation. It is probably a combination of both, but it is hard to know which is the dominating factor.

The ECB’s announcement last week is not a good test because it announced additional monetary stimulus as well as lower interest rates.

Gold would react favorably (for gold bulls) to additional monetary inflation for obvious reasons. A depreciating currency means a higher price for hard assets, at least over the long term. And gold is more sensitive to monetary changes, as it is a natural hedge against inflation.

In terms of negative interest rates, this could also be inflationary if the banks react the way the ECB wants them to react. If they lend more money, this is fractional reserve lending that essentially injects new money into the system.

But even if banks do not significantly increase their lending, they may decide to pass on their increased costs to their customers. In other words, people will have to pay the banks to hold their money for them.

This in itself could attract people towards gold. Most people don’t want to put a lot of money under their mattress. But it is easy to invest in gold, and it doesn’t have to be in physical gold. It makes sense that some people are figuring out that they would want to hold gold – whether in physical form or through gold funds – over keeping money in the bank and paying interest to the bank in the process.

The ECB, the Bank of Japan, and other central banks really don’t know what they are doing right now. They are just digging a deeper hole and distorting markets severely. At least it is a bright spot for gold investors, if nothing else.