Gold's Surge Wreaks Havoc on Wall Street Inflation Models

Strategists who thought gold was signaling disinflation are realizing it wasn't signaling much of anything. What do you think? Tell us on our message board.
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The 79th element on the periodic table has not been without its uses.

It has been used in dentistry since at least the seventh century BCE, when the Etruscans used it to attach replacement teeth. The 16th century Danish astronomer

Tycho Brahe

took that a step further when he fashioned a prosthetic nose out of the stuff -- greatly improving his looks. It was used in the faceplates that the

Apollo

astronauts wore. Today, it's used in a number of electronic components. And if nothing else, with an atomic weight of 196.97, gold makes a darn good paperweight.

But when it comes to forecasting inflation, its use as a leading indicator has become suspect at best.

Does gold mean anything for inflation? Tell us on our

message board.

In the years that followed the abandonment of the gold standard in 1971, gold's history as the basis as the world monetary system continued to exert a powerful influence on investor psychology -- when people began to worry about inflation, they'd move into gold, and the price would rise. But over time, belief in gold as a store of value, and hence its usefulness as a predictive tool, has waned. A 1995

Kansas City Fed

paper showed that gold's worth as a leading indicator deteriorated significantly in the 1983 to 1994 period vs. the 1973 to 1982 period. In recent years, central-bank reserve selling has further muddied gold's value as an economic divining rod.

"The traumatic allocation shift by central banks that contributed to the extensive breakdown in gold prices has made it almost impossible to make a read on what gold prices mean for inflation," says Doug Cliggott, market strategist at

J.P. Morgan

.

Yet for all that, some forecasters have persisted in using gold as a major part of their econometric models -- much to their chagrin, no doubt. The recent bounceback in the metal, after European central banks agreed to limit sales over the next five years, has thrown a wrench into their forecasts. Consider what the economists at

Bear Stearns

, led by former Kansas City Fed Gov.

Wayne Angell

, wrote just two weeks ago:

The Fed would be better served by using gold as an inflation predictor rather than the Phillips Curve. Since ... early June, gold has fallen about $10 per ounce, to around $255 per ounce, which is consistent with a downward revision to the inflation outlook for the next four quarters of about one-quarter of a percentage point, according to our model.

"We had thought that when gold prices were hovering around $250 to $260, that was pointing to continued disinflation. It seems it was more reflective of positions in the market and central bank sales," admits Bear Stearns economist Melanie Hardy. "These kind of things happen."

Hardy says the zigzag in gold in no way diminishes Bear's general confidence in gold's use as an economic indicator.

Others are amazed that, given that the problem with central-bank selling wasn't exactly a secret, economists at Bear persisted in relying on gold for their modeling.

"I could never reconcile how they could keep pointing to gold and say we have more disinflation in the pipeline," says Tony Crescenzi, bond market strategist at

Miller Tabak

. "They had their focus on the wrong place."

Just as the breakdown in gold prices did not augur disinflation, it's unlikely that its bounceback means all that much for the inflation picture. "Gold has lost its anchor as a barometer of inflation expectations," says

Morgan Stanley Dean Witter

chief economist Stephen Roach, who has been looking for a return to more historical inflation levels. "It would be completely hypocritical for me, as someone who watches for inflation, to turn around and cite a trend that I have long discounted."

Yet while the bounce in gold may not change what inflation is going to be, it does change inflation expectations. "Gold was sending misinformation, and it distorted the true picture," Crescenzi says. The bounceback showed the extent to which central-bank selling has influenced gold's price, further discrediting its use as an indicator. With the market lowering its confidence in the glittery stuff, the inflation outlook isn't as rosy as it once seemed.