A Precious Barometer

What the rising price of gold may suggest about the state of the global economy.

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Gold is an oddball among commodities. It isn't produced for mass consumption. It isn't eaten or burned for energy. In fact, outside of small roles in dentistry and electronics, the metal has few practical uses. Even in the form of jewelry, the amount the average U.S. consumer spends on gold is minuscule. Yet the price of this glittery commodity has skyrocketed to nearly $800 an ounce from $250 in 2001.

What sets gold apart is that it's prized simply because it's valuable. For centuries, gold has been regarded as a safe haven, a place to stash your nest egg in case financial calamity strikes. Investors tend to place their bets on gold when they're worried about a pickup in inflation, which erodes the dollar's purchasing power. "Gold is one of the best forward-looking, market-based indicators of inflation," says Donald Luskin of Trend Macrolytics, a California-based consulting firm that caters to institutional investors.

By that measure, the stampede into gold suggests that inflationary fears are currently running high. Investors' expectations about inflation often turn out to be accurate, Luskin says. Over the past quarter century, when gold prices rose more than 10 percent over a two-year time span, the rate of inflation increased over the following two years about 85percent of the time, according to Luskin's research. On the flip side, when gold prices fell over such periods, the rate of inflation fell about 70 percent of the time.

Gold prices, which have been on an upswing since 2001, accelerated their climb after Federal Reserve Chairman Ben Bernanke hinted at a rate cut on August 31. Following the Fed's half-point rate cut on September 18, gold prices surged again.

"Once it became apparent that the Fed was going to reduce rates, investors reacted by bidding up stocks, bidding up gold, and bidding up treasuries on fears of an economic slowdown and the introduction of more liquidity into the system—which means potentially more dollars chasing around the same goods and services," says Michael Cuggino, manager of the Permanent Portfolio fund, which invests in a mix of asset classes, including gold, natural resources, and real estate.

Other than reflecting fears about inflation, soaring gold prices may point to something more ominous: a flight from dollar-based investments. "It's the purest indication of investors' dissatisfaction with other asset classes and a criticism of what cash is worth," says Axel Merk, manager of the Merk Hard Currency fund. "That's what makes gold so scary to policymakers. If people think gold is worth more than buying stocks or bonds, then they think something is wrong with the economic system."

Foreign investors may be feeling the same way. Market analysts are increasingly concerned about foreign banks shifting some of their reserves out of dollars and treasury securities. "The rest of the world now has more choices, whether it's the euro, baskets of currency, and so on," says Jim Swanson, chief investment strategist at MFS Investment Management. "The world community is saying, 'We don't trust you, the U.S., to be the guardian of your own fiat currency.' This is a vote of lower confidence in how the U.S. is managing its affairs."

At least some of gold's spectacular climb can be explained by increased demand for gold as a raw material in emerging countries. "We're in a long-term bullish phase with gold that's separate from the currency crisis," Swanson says. Although jewelry sales are declining in the United States, demand is rising among newly affluent consumers in China, India, and the Middle East. Meanwhile, reserves are diminishing. Gold has also gotten a boost from the arrival of exchange-traded funds, which allow people to invest in the metal without the hassle of holding the physical commodity.