Slumping gold price is no mystery; it's a function of deflation

Imagine a Rube Goldberg contraption. An ounce of gold tips one side of a creaky scale. Near the other end stands a puzzled investor with thick wallet in hand. Right now the price of that ounce of gold has fallen below $300 -- a slide of $50 since last July and of $100 since last February. The investor is puzzled because he remembers that only four years ago that same ounce of gold cost him $875.

Gold's price per ounce changes according to a Goldbergian set of complexities surrounding our hypothetical investor. These include inflation; interest rates; monetary policy; the value of the dollar; sales by gold-producing countries such as South Africa and the Soviet Union; purchases by the central banks of other countries; even such abstracts as optimism or pessimism about the future.

An investor piles more or less money into the scale according to how he is booted or poked by these conditions. In the late 1970s, investors were so harassed by worries about runaway inflation and world political order that they threw good money after bad into the scale. Gold peaked at $875 an ounce in January 1980.

Investors drove up the price of gold because the metal (and its cheaper companion, silver) traditionally has been considered the ultimate hedge -- a standard of exchange that has outlived every currency in world history and that probably still would be legal tender if civilization were to collapse. It's where you put money if you believe times are bad and getting worse -- and especially if you think inflation is getting worse.

But since 1980, world economic conditions have changed dramatically. Oil prices have dropped. Inflation, too. Interest rates are still high in real (inflation-adjusted) terms, but they have been weakening. The dollar has soared. Just as important, perceptions about the future have been altered: It may seem a broad generalization, but economists note that optimism appears stronger today than it was at the end of the '70s.

Consequently, the price of gold has fallen. On Tuesday it dropped to $296.70 on the New York Commodity Exchange, its lowest level in 51/2 years. Gold was fixed Wednesday afternoon at $300.50 an ounce in London after falling to $298.35 earlier in the day.

Where is gold heading, and what does this say about the world economic outlook?

Gold traders, analysts, and investors concur that there are few reasons for gold's fall to be reversed anytime soon.

``It looks like 1985 will be a hostile economic environment for metals,'' says Jeffrey M. Christian, senior precious metals analyst for J. Aron & Co., a subsidiary of the Goldman, Sachs & Co. brokerage. But a gradual decline -- not a free fall -- is the more likely scenario for gold, Mr. Christian and other analysts say. He notes some ``disillusionment selling'' among traditional gold horders such as Middle Easterners. There has been considerable short selling (borrowing gold and selling it in the hopes of repurchasing at a lower price) in recent days, too, especially in New York, he says.

Ronald Hersch, manager of metals trading at Shearson Lehman/American Express, sees gold prices stabilizing and perhaps even climbing if the dollar weakens and oil prices hold firm. But that is rather a long shot, he admits, and currently ``the oil price decline bodes well for the inflation outlook and makes dollar-denominated assets attractive'' instead of gold.

Hersch says he thinks it is possible that gold could trade this year in a range of $265 to $340 an ounce.

The dramatic decline in gold prices reflects a broader decline in commodity prices -- a phenomenom economists call deflation. Reasons behind commodity deflation are many. In general, world demand for many commodities has fallen far short of supply. Nations that produce commodities -- especially oil -- find they must sell their prime export at lower and lower prices. That drives inflation down and gold down with it.

All of this seems good to people who drive cars, heat their houses, and otherwise employ basic commodities. But if commodity prices fall too far, exporting nations have trouble making loan payments to banks. So do American farmers and oil companies.

The US Federal Reserve System appears to recognize the importance of these interdependencies. Last August, to stave off an onslaught of deflation, the Fed began to increase the money supply -- to ``reflate.'' When the Fed lowered the discount rate Dec. 21, it noted its concern about declines in commodity prices.

The Fed's easing of the money supply has led many economists to believe that inflation may accelerate slightly in the months ahead. And that could help slow the fall in gold prices. But militating against a surge in inflation is the weakness of oil prices. While inflation might pick up in 1985, it probably will (see correction below) be enough to cause a recovery in gold prices, financial analysts and economists say.

``I see gold trading in a range of $260 to $380 an ounce in 1985,'' says Charles R. Stahl, publisher of Green's Commodity Markets, a Princeton, N.J., newsletter that tracks commodities. ``The reasons are the strong dollar, low inflation, and weak oil prices. . . . But late in the year I think we could get higher inflation and a weakening of the dollar because of the balance of trade problem.''

Mr. Stahl notes that the 1980 peak was just after the Soviet invasion of Afghanistan, during the Iranian hostage crisis, and at the outset of the Persian Gulf war. The international climate has settled down somewhat since then. ``We've even started talks with the Soviets,'' says Stahl, ``and that takes the bloom off gold.''

John van Eck, chairman of New York-based International Investors, which operates a mutual fund that invests in gold, admits the precious metal is ``a very volatile commodity'' and that it ``has certainly taken a nose dive this year.'' Nonetheless, Mr. van Eck sees gold as being on a ``long-term trend up.'' If deflation is steep today, there will be higher inflation next year, he contends, as the Fed tries to prevent a commodity price collapse. Gold prices, he argues, will ride up with that higher inflation.

In an article Thursday on falling gold prices, a sentence on Page 5 should have read: ``While inflation might pick up in 1985, it probably will not be enough to cause a recovery in gold prices, financial analysts and economists say.'' The word ``not'' was left out of the original sentence.

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