If Interest Rates Rise, What Happens to Gold Prices?

The fact that gold prices rose astronomically from 2008 to 2011 near the same time that the Fed lowered interest rates is no coincidence. Gold prices rise and fall for a number of reasons, many of which have to do with the state of the U.S. economy. How gold prices react also has everything to do with how the Federal Reserve sets interest rates.

Interest Rates

The Federal Reserve sets interest rates in the United States. The chairman of the Fed uses interest rates like the handle of a faucet: Raising interest rates slows the stream of dollars dripping into the economy, which in turn contracts the money supply. Lowering interest rates, on the other hand, accelerates the stream of money flowing through the economy. In times of high inflation caused by the abundance of money in the economy, the Fed typically raises interest rates in an effort to curtail rising prices. On the other hand, a steep recession may prompt a Keynesian-leaning Fed chairman to lower rates.

Gold Prices

Gold prices rise out of fear and market expectations. Fear of inflation, conflicts overseas and economic collapses push gold prices higher. Additionally, strong demand for gold from other nations, such as China, also causes gold prices to rise. An April, 2011 "MSN Money" article explains how better-than-expected job figures coupled with less demand for gold contributed to a small decline in the price of gold.

Relationship

Interest rates control the money supply, thereby controlling the strength of the U.S. dollar. High interest rates constrict the money supply because fewer institutions borrow money. This contraction of the money supply causes the dollar to grow stronger. When less money is in circulation, the dollar's scarcity causes it to become more valuable. In turn, fewer dollars are necessary to purchase gold. Furthermore, investors gravitate towards dollar-backed assets instead of commodities when the dollar is strong. Thus, high interest rates cause the price of gold to drop. Even the expectation of an interest rate hike is enough to send gold prices lower.

Considerations

Gold prices are particularly sensitive to changes in the interest rate because of the dollar's role as the world reserve currency. This status is reflected by countries buying essential commodities such as petroleum in dollars and other nations pegging their currency to the dollar. However, a "Wall Street Journal" article explains how the International Monetary Fund is considering replacing the dollar as the reserve currency with a synthetic base currency whose value is determined by a compilation of currencies. If less emphasis is placed on the dollar for financial transactions, the relationship between gold and interest rates will become significantly weaker.

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