The recent uptick in inflation expectations is the outcome of economic data releases for employment, wages, and inflation coming in stronger than the market was expecting. On the other hand, retail sales and manufacturing data have been weaker than market expectations, painting a mixed picture.

It would be premature at this stage to think that inflation is reversing course and moving higher, but it is becoming increasingly clear that inflation will not leave without a fight and should be expected to take longer to soften than most market participants were expecting only a few weeks ago.

The Fed has no compelling reason at this time to start scaling back on interest rates and is expected to maintain its recent wait and see mode. This expectation is in line with Jerome Powell’s comments at the end of the last Federal Open Market Committee (FOMC) meeting. While the market has lowered its expectations for interest rate cuts this year, the CME Group’s Fedwatch tool still suggests that the market is looking for four interest rate cuts starting at the June FOMC meeting. Though this is more closely in line with the three rate cuts the Fed was suggesting via its projection materials released in December 2023, it may still be too optimistic on the part of the market both in terms of timing as well as scale.

Services inflation has been holding up particularly strongly, in large part because of the strong labor market and in part because of past lagging of this sector to other segments of the economy. Core inflation was stuck at 3.9% over the course of December 2023 and January 2024 and was down from 4% where it stood during October and November. If inflation shows signs of stagnating the Fed would not hesitate to keep rates higher for longer.

The markets and Fed are counting on a reduction in shelter inflation. The tight supply of housing inventory and still healthy demand for housing has prevented owners’ equivalent rents from falling in any meaningful way and shelter inflation was in fact the largest contributor to the strength in January core inflation. While part of the strength in shelter inflation can be explained by tight housing market conditions part of it also has to do with the way in which inflation is calculated and the lag effect between the actual market conditions and the reported data. Even though shelter inflation may come down in coming months, the pace of decline may not be as strong as expected, which should slow the downward trajectory of inflation.

While not the base case at this time, there also is the potential for the Fed to raise rates in the future if inflation does not show signs of improving. Monetary policy typically acts with a lag and the full impact of the tightening cycle is more likely to be felt and seen over the course of this year. The Fed is unlikely to move in the direction of tightening monetary policy unless there is compelling and clear evidence that inflation is not declining and could potentially rise going forward.

While the possibility of inflation rising once again exists, it still is too early to suggest it with confidence given the mixed state of economic data.

That said, looking at how current economic data is evolving and that financial conditions in the economy remain relatively loose, the Fed is likely to hold its federal funds rates higher for longer than the markets were expecting just recently. This could create headwinds for gold going forward with bond yields and the dollar strengthening amid stronger economic growth.

Interest rates remaining higher for longer or possibly even increasing could put undue stress on some of the weaker segments of the financial markets, the most easily observable one being the commercial real estate market.  

A readjustment in markets toward tighter than expected monetary policy coupled with a phasing out of the seasonally strong period for precious metals prices could weigh on the prices of these metals over the next few months. This should create a buying opportunity, given the various domestic and international political issues that continue to threaten growth and the possibility that a revival in inflation tips the economy into a recession sometime in late 2024 or 2025.

A Note On Gold Investment Demand

The first chart in this section shows CPM Group’s estimates of the total amount of gold held in bullion bar and coin form worldwide. In addition to the gold held by investors, gold held by central banks also has been shown in this chart.

Investors hold more than 1.4 billion ounces of gold bullion as of the end of 2023. The bulk of this was in bullion bars and coins held by investors either directly or in depositories. Included in this total was the 122 million ounces held by investors via ETFs at the end of last year. ETF investors accounted for nearly 9% of total physical gold holdings. Insofar as these investors otherwise might not have bought physical gold through any other medium, this was incremental additions to global investor gold holdings.

Indeed, one of the interesting aspects of the rise of gold ETFs since they were first introduced in 2003 is that the majority of gold ETF investors have not been traditional physical gold investors, but rather have been either (a) gold mining share investors moving from gold mining equities to gold ETFs or (b) institutional and individual investors who previously had not invested in gold assets at all. Rather than cannibalize physical gold investment demand, gold ETFs brought new investors into the gold bullion market and increased the overall volumes of gold being bought and held by investors helping to support prices.

The amounts of gold held by investors, directly in physical bullion bars and coins, and via ETFs, is only one metric. Another important measure is the change in these levels, and in this respect there has been a very important divergence over the past three years.

Since 2021 investors have been reducing their gold holdings in ETFs even as they have been buying heightened volumes of physical gold overall – 22.8 to 26.5 million ounces per year.

While investors have been buying historically high volumes of gold directly in bullion bars and coins, they have sold around 23 million ounces of gold held in ETFs. These sales have represented a rise in counterparty risk concerns related to ETFs more than they have reflected a desire to reduce gold exposure.

Some of those investors selling ETF positions have replaced those shareholdings with physical gold held in depositories on either an allocated or unallocated basis.