Gold closed higher on Thursday, despite a CPI report and other data that convinced many inflation is not a problem and that the Federal Reserve will cease raising interest rates sooner rather than later.

But gold, which serves as a hedge against inflation, still found cause to rally. First, the dollar took a hit after the CPI report. The Fed's 20-month-long campaign to raise rates has provided key support to the greenback. Gold, which is priced in dollars, normally rises when the dollar drops, as it takes more money to buy the same amount of the precious metal.

Second, crude oil prices, which gold has been tracking recently, jumped $1.41, or 2.3%, to $63.58 per barrel after the U.S. launched its largest air attack in Iraq in three years.

The result: Gold for April delivery gained $1 to $555.40 per ounce, marking its fourth straight session of upside, for a total gain of $14.10.

The metal's advance didn't do much for gold-mining stocks, which have remained depressed since gold took a corrective turn in February. The Amex Gold Bug Index dropped 1.2%, led by big declines in El Dorado ( EGO), Gold Fields ( GFI) and Hecla Mining ( HL).

The CBOE Gold Index dropped 0.7% and the Philadelphia Gold and Silver Index fell 0.8%.

News of the Iraq attack also helped erase some of the early gains for stocks. The Dow Jones Industrial Average rose 43 points, or 0.4%, to 11,253. The S&P 500 rose 0.2% to 1305, but the Nasdaq Composite dropped 0.5% to 2299.

Rate-sensitive issues, such as homebuilding stocks, were sharply higher, however. The Philadelphia housing sector index rose 1.6%, lifted by strong gains in the likes of Toll Brothers ( TOL), Standard Pacific ( SPF) and KB Home ( KBH).

Wither M3?

Apparently, there's more to the story behind gold's resilience than tame inflation. Gold bugs love a good conspiracy theory, and they actually have a fairly convincing one.

The CPI, many gold bugs believe, is not to be trusted. A real gauge of inflation, they argue, is M3, which is the largest measure of the money supply. And guess what? That weekly measure, which used to rock the bond and stock markets in the 1970s, is going to be scrapped on March 23.

The explanation on the Fed's Web site reads: "M3 does not appear to convey any additional information about economic activity that is not already embodied in M2 and has not played a role in the monetary policy process for many years. Consequently, the Board judged that the costs of collecting the underlying data and publishing M3 outweigh the benefits."

If you ask gold bugs, however, the Fed is trying to hide something. M3 includes the smaller measures of the money supply, such as M1 and M2, plus large time deposits, institutional money market accounts, and eurodollar deposits of U.S. banks held at foreign branches and at all U.S. offices. While the first two measures are mostly held by the public, M3 is about putting "money into the system," writes David Chapman, director of the Millennium Bullion Fund.

The first leg of today's inflationary environment, Chapman says, started when former Fed Chairman Alan Greenspan cut rates in the early 1990s to stave off a recessionary environment. The latest leg came after the Fed cut rates to historical lows after the bursting of the tech bubble and the 9/11 attacks. Since 1995, M1 has risen 18.8%, M2 is up 89.5%, and M3 has increased a stunning 130%, Chapman notes.

"The Fed has been running a well-managed hyperinflationary environment," says John Strafford, a gold analyst and editor of The Strafford Newsletter. "They must inflate or die."

But why remove M3 now?

Iran was expected to launch an exchange next week to start trading its oil in euros instead of dollars. Given current geopolitical tensions, a possible huge rush out of dollars would occur, and that would have hit M3 the most. A sharp drop in M3 has typically been seen as presaging recession, and markets would have panicked, says Chapman.

Meanwhile, it seems that Iran's launch of the bourse has been delayed until April, according to Platt's Commodity News.

According to John Lonski, chief economist at Moody's and a veteran Fed watcher, the Fed is not trying to hide something. "M3 is less relevant now than it was in the 1970s, given thin evidence that monetary growth is correlated to inflation nowadays," he says.

Disinflationary pressures from cheap labor and production in Asia have contributed to making M3 less relevant, Lonski adds. However, it may become relevant again in a few years' time once Asian economies mature.

Moreover, as long as most market participants believe there's no inflation, then there's little to worry about, as prices don't get out of hand. "Perceptions matter a great deal," Lonski says.

But gold bugs, who believe that the U.S. economic imbalances such as the swelling current account deficit are not reflected in the current value of the dollar, will continue to believe in the precious metal's upside.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback; click here to send him an email.

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