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7 Key Questions About Gold Prices

By David Sterman

NEW YORK ( TheStreet) -- Gold prices spiked to an all-time high of almost $1,300 an ounce on renewed speculation the Federal Reserve will extend a plan to stimulate the economy, strengthening the case for safe-haven assets.

Still, with a rebounding economy, gold's ascent may soon be running out of steam. Here are seven key questions about the direction of the precious metal.

Question: What is the Fed concerned about?

Answer: In its most recent statement after Federal Reserve Open Market Committee (FOMC) meetings, the Fed noted that potential deflation is of increasing concern. (Core annual inflation has been running at 0.9% for five months in a row, its slowest pace since 1966.) Any drop in prices could spell real trouble for the economy and would imperil borrowers seeing lower income but constant debt levels.

Q: What might the Fed do?

A: To help support prices, the Fed could inject money into the economy by buying back bonds. The bondholders that sell their debt back to the government would presumably put that cash to use elsewhere in the economy.

Q: Why should that affect gold?

A: Many fear that the Fed is simply inviting the prospect of troubles down the road. Early in the past decade, the Fed also sought to boost the economy's prospects by keeping interest rates low. That set the stage for rampant low-cost borrowing and an eventual housing boom, which turned out to be disastrous for the economy when the music stopped.

This time around, the concern instead focuses on what might happen if the economy hums back to life but the Fed has a hard time keeping growth (and inflation) from surging. In the recent economic bubble, inflation never emerged. Yet gold bulls insist that we won't be so lucky next time. That's because budget deficits are now far higher, and if the United States can't meet its obligations, then inflation will rise as the Fed raises interest rates to keep attracting buyers for its debt. That would cause the dollar to weaken and gold would provide shelter.

Q: What's the upside for gold?

A: Ah, the crystal-ball question. Bulls think it can move toward the $2,000 per ounce mark, which is actually the all-time high when adjusted for inflation. (Read The Truth About Gold.)

Why that price? There seems to be no real way to peg an actual projected value on gold. The price is driven by sentiment and not any sort of underlying asset value. We can figure out global demand for gold, and also how much is being produced each year. But we don't have a clear read of how much actual gold is sitting in central banks and especially in safe-deposit boxes. Contrary to popular belief, central banks tend to offer contradictory statements on their gold holdings to keep currency speculators from knowing the state of their finances.
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