The Federal Reserve announced a quarter-point rise in the federal funds rate on Tuesday and futures markets have priced in another quarter-point hike for May, which would bring the key overnight interest rate to 5 percent. The positive or negative economic impact of continued rate hikes aside, the price of gold is what many Fed-watchers will study to gauge the effect of the rate increases. Yet, perhaps surprisingly, nominal fed funds rate increases have rarely succeeded in bringing down the price of gold.
While this phenomenon in part can be explained by the fact that rate hikes have often occurred amidst inflationary episodes, economist Alan Reynolds has made the point that the “Fed should remember that countries with sustained low inflation never have high interest rates, so high interest rates cannot be the route to low inflation.” Evidence since 1971 seems to confirm his thesis.
Following the collapse of the Bretton Woods system — whereby the value of the dollar was no longer fixed in terms of the price of gold — the fed funds rate jumped from 3.5 percent in November 1972 all the way to 13 percent in July 1975. During that time the price of gold rose 242 percent. From July 1975 to April 1977, the bank rate fell from 13 percent to 4.75 percent. This occurred alongside a 23 percent drop in the gold price.
In May 1977 the Fed began tightening again, with the fed funds rate rising from 5.25 percent that month to 17 percent in April 1980. Despite this large nominal rate rise, the price of gold skyrocketed from $150 to $540 an ounce.
Interest rates reached a high of 19 percent in June 1981 with gold at $470, and although the rate was down to 9 percent by 1983, rather than rise, the price of gold fell nearly 20 percent to $400 an ounce. Notably, gold briefly spiked to $850 in February 1980 with the fed funds rate at 14 percent. Fed tightness around this time is traditionally given credit for gold’s subsequent fall, but it can be argued that the passage of the Reagan tax cuts in 1981 was even more effective, with investors buying dollar-denominated assets (and sopping up excess dollar liquidity) ahead of the economic growth that resulted from the tax cuts.
Jumping ahead a few years, the fed funds rate fell from 8.25 percent in December 1985 to 5.75 percent in October 1986. The price of gold? It actually rose during the period, from $320 to $430 an ounce, though the case can be made that interest-rate changes played a minor role versus the 1985 Plaza Accord, in which the G-5 countries agreed to an “orderly appreciation of the main non-dollar currencies against the dollar.”
How about the gold price in periods of interest-rate stability? From January 1996 to December 1997, the fed funds rate held at 5.5 percent. Meanwhile, gold went into freefall, dropping from $395 an ounce to $290. The 40 percent cut in the capital gains rate in 1997 is frequently credited for gold’s fall, as the Fed failed to provide the extra liquidity needed after such a substantial lowering of the cost of investment risk.
The Fed began tightening again in July 1999, lifting the key interest rate from 5 percent to 6.5 percent in November 2000. Amidst this seeming austerity, gold actually rose from $258 to $265 an ounce. In December 2000 the Fed began lowering the bank rate once again, from 6.5 percent to 3.75 percent in July 2001. After 275 basis points in rate cuts, the gold price was largely unchanged.
The interest rate cuts that began in December 2000 and continued through July 2003 are commonly credited for driving the price of gold out of deflationary territory. Gold did rise 30 percent during this period, but the role of interest rates is once again debatable. During the timeframe in question, the U.S. experienced 9/11 as well as the introduction of tariffs on steel and softwood lumber. The latter were an implicit admission by the Bush administration that it wanted a weaker dollar, while the 9/11 tragedy’s monetary impact was likely one that drove the marginal investor into tangible assets like gold.
Since June 2004 the Fed has raised interest rates 375 basis points. Meanwhile, gold has risen 43 percent. Certainly increased protectionist sentiment in Congress has been one endogenous factor causing the gold price to rise, but given the historical impact of rate hikes on the price of gold, is it a certainty that the latter would be any higher today had the Fed simply done nothing in 2004?
None of this is to judge whether expected interest-rate hikes in May are a good or bad idea. This chronology is meant to show just how ineffective rate machinations have been in controlling the price of gold. Returning to Alan Reynolds, the economist has written that “If a central bank is worried about inflation, it should suspend any purchases of government debt for a while.” And if gold is but one input in the Fed’s inflation strategy, those in charge would do well to heed his words.
–John Tamny is a writer in Washington, D.C. He can be contacted at firstname.lastname@example.org.