$900 Gold: What's Behind It?

Inflation fears and geopolitical uncertainty stoke price rises. Some experts think they'll continue.

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With all the chatter about the possibility of $100-a-barrel oil, you might have missed the other benchmark commodity that recently moved into uncharted territory: gold.

Just days into the new year, the price of gold broke through its previous all-time high of $850 an ounce—which it set back in 1980, amid skyrocketing inflation and Middle East tensions—to briefly touch $900 Friday on the New York Mercantile Exchange and to close at $891 in London.

Why has the gold price soared?
Fresh geopolitical and economic fears are most responsible for carrying gold past its previous record, says Jon Nadler, a Kitco gold analyst. The assassination in late December of Pakistan's former Prime Minister Benazir Bhutto plunged an already volatile, nuclear-armed nation into political chaos. Meanwhile, a growing number of economists have concluded that the U.S. economy will indeed tip into a recession this year.

Gold prices tend to rise during such periods of turbulence, as investors move money from more volatile investments, like stocks and bonds, into the relative safety of gold. In response to the recent developments, "people are saying, 'It looks like I should raise my allocation of gold from maybe 3 to 5 percent to as high as 8 to 10 percent,' " Nadler says. "In a small market like gold, that makes a big difference." Bigger players, such as hedge funds, have also contributed to the higher prices and increased volatility, Nadler says.

The price of gold has been on the rise for most of the decade but surged 30 percent in 2007. Last year's spike was rooted in a number of factors, including the weakening U.S. dollar, rising oil prices, higher demand for gold from India and China, increased mining costs, and the introduction of gold exchange-traded funds, which have allowed more investors to put their money into the precious yellow metal. But late in the year, growing Middle East tensions, coupled with the U.S. housing crisis, injected an additional level of fear into the market that boosted gold prices further.

So what does this mean?
The short answer is: Investors are scared. And why shouldn't they be? In the face of falling home values, troubled credit markets, the war in Iraq, and rising unemployment, the stock and bond markets seem increasingly risky in the near term—the Standard & Poor's 500 index is already down 3 percent this year. That makes a vehicle for capital preservation like gold all the more appealing.

Furthermore, some economists see gold as a leading indicator of inflation. David Gitlitz, the chief economist at Trend Macrolytics, says that record gold prices mean a nasty fight with rising prices is right around the corner. "People are worried now about whether this whole financial market freak-out is going to throw us into a recession," Gitlitz says. "The real recession, though, comes when this inflation data hits, and the Fed is going to have to respond."

Where is gold headed from here?
With gold at an all-time high in dollar terms (although, adjusting for inflation, gold prices were much higher in 1980), Carlos Sanchez, a precious-metals analyst at CPM Group, expects a round of profit-taking to drive prices down in the near term. But he expects gold prices to rebound and continue trending upward throughout 2008.

"The economy is headed for slower growth, the stock markets have been declining, and I am expecting a decrease in interest rates, which will put further pressure on the dollar," Sanchez says.

Nadler, meanwhile, expects gold prices to remain high for the first part of the year but predicts a pullback in the second half. "The nearly vertical ascent [of gold prices] is starting to look like a mania phase," he says.