Ian Telfer: Fed signals inflation ahead so what’s ahead with Gold

To no one’s surprise, the U.S. Federal Reserve raised interest rates by a quarter point December 14th, the first increase this year. Gold prices have been drifting lower in anticipation of a hike, while the U.S. dollar remains strong. While the market had largely factored in a .25 point increase, the one thing that did raise eyebrows and boost treasury yields was the forecast for three increases next year.

It had been thought that a realistic number would be closer to two for 2017, but Federal Reserve Chair Janet Yellen signaled a faster pace of increases in 2017 given some generally positive economic data. Interest rates are the tool normally used by the Fed to control inflation, which tends to rise when economies heat up.

"In view of realized and expected labor market conditions and inflation, the committee decided to raise the target range," she said after a two-day meeting.

The main takeaway for those who invest in Gold is that if the Fed thinks inflation will prove to be a bigger factor as the economy heats up in 2017, it points to higher precious metals prices.

Gold is seen as a hedge during times when inflation rises. The conventional wisdom is, and history has borne this out, that when consumer prices rise, it is because the buying power of our currency is less than what it was. Gold is seen as a store of value and therefore viewed as a safe haven when paper currencies are under pressure.

Casey Research illustrates the correlation between Gold prices and interest rates in a chart showing the metal going up after the Fed started raising rates in 2004. It’s understandable that the public would be somewhat confused by this because Gold prices tend to dip when rumours of an impending interest rate hike begin to circulate. That’s because rate hikes have the effect of strengthening the value of the currency, in this case the U.S. dollar in which gold is priced.

Yet, as we see in that chart, rate hikes that are the product of inflation resulting from an overheating economy can also track gold prices higher.

What I’m suggesting is that while Gold prices have fallen since the November 8th U.S. election, that trend may reverse itself in the year ahead given a number of factors, including an increased demand for physical gold. Interest rate hikes are just one factor. Let’s not forget also that with Italian banks on shaky ground and a possible ‘brexit’ style referendum coming in that country, the Euro may come under pressure in 2017 during which investors may want to dump the currency in favour of Gold, U.S dollars or Swiss Francs.