How central bank policy affects the gold price

'People rightly buy gold when they see inflation ahead,' said William Rees-Mogg at a private investment seminar in the City of London on Thursday evening.

A member of the House of Lords and a former advisor to Margaret Thatcher he added that 'I believe today inflation should cause us to be very anxious once again.'

Let's roll back to the last time that inflation was the No.1 cause for panic attacks amongst the world's home-owning democracies. His Lordship's point is well made.

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By 1979, in fact, inflation was hurting every country for which there are data.

In the United States inflation hit 12.8%; in Israel it hit 132%; globally, said the International Monetary Fund, the cost of living increased by 15.6% in just 12 months. Put another way, the value of money worldwide dropped one-sixth of its spending power in the last year of the '70s an unprecedented collapse.

'In the price-revolution of the twentieth century,' writes David Hackett Fischer in his study of inflation in history, The Great Wave, 'more than half of the total increase in prices from 1896 to 1996 happened after 1970. Nine-tenths of it came after 1945.'

Previous explosions in the cost of living had taken decades...even centuries...to unfold. But the '70s bubble in guns and butter put the pedal to the metal. Inflation raced ahead as never before.

The economic response, however, was more familiar.

'Wages, which had at first kept up with prices, now lagged behind,' says Hackett Fischer. 'Returns to labor declined while returns to land and capital increased...[and] interest rates were driven up.'

This same pattern was seen in the great medieval inflation of 13th century Europe; again in the global price revolution of the 16th century; and also in the 18th century inflation that preceded the revolutions in North America and France.

You might just happen to think we've witnessed similar trends during the last 5 years, too. For despite living through what central bankers laughingly call 'The Great Moderation', all the evidence points to a surge in the cost of living. All the evidence except the inflation data, that is.

Real wages have failed to keep pace with energy and food costs. Wealth inequality has gaped open, creating billionaire speculators in Manhattan and London even as middle-income families have been priced out of buying even modest properties by a bubble in real estate trading from Florida to Bulgaria...Thailand to Spain.

But the 20th century inflation that may or may not have peaked out at the close of the 1970s also saw one big difference; for while interest rates rose in response to higher inflation, they didn't rise fast enough. Holding cash regularly destroyed wealth during the '70s; real interest rates paid less than zero in 41 of the 48 months between 1974 and 1978.

What had changed? In two words, central banking.

Why 1970s inflation was different

Before World War II, gold was a key part of the global monetary system. After the Bretton Woods agreement of 1946, the world's currency system was then tied to the US Dollar instead.

Yes, the Dollar continued to be backed by gold, in principle at least. But by 1971, the United States government was printing so many paper Dollars to fund its policy of war plus welfare, Richard Nixon opted to severe this final link too. That move set free governments everywhere to print money as they chose. Now there was no gold backing each Dollar, Peso or Pound. And as the money supply soared, so the value of money evaporated.

You've got to wonder is this why the 20th century Price Revolution also displayed another big difference compared to its precedents? Over the six decades to 1980, the real value of gold actually rose. This hadn't happened in three centuries of British data, according to Professor Roy Jastram of the University of California at Berkeley. His studies in the mid-70s found that gold had previously failed to keep pace with the cost of living whenever inflation turned higher. In the United States, Jastram said, the purchasing power of gold fall by more than one-fifth on average during the inflations he studied from 1808 onwards.

Only the final period in Jastram's study beginning in 1951 saw the metal gain value. It continued to gain purchasing power right up to that famous top above $850 at the start of 1980. Meantime, those negative rates of real interest paid on the US Dollar slowly destroyed confidence in the world's primary unit of account.

Volcker tackles gold speculation with higher rates

What to do, wondered the Feds. Back in 1933, during the United States' previous crisis of confidence, Washington forced US citizens to accept paper Dollars with the threat of $10,000 fines or imprisonment if they were found hoarding or trading gold. In late 1979, at one of the policy meetings led by Paul Volcker, the Federal Reserve committee noted the threat of 'speculative activity' in the gold market. It was spilling over into other commodity prices. One official at the US Treasury called the gold rush 'a symptom of growing concern about world-wide inflation.'

'We had to deal with inflation,' as Volcker said in a PBS interview of Sept. 2000. 'There was a kind of great speculative pressure.

'It was the years when everybody wanted to buy collectibles from New York. The market was booming, and other markets of real things were booming because people had got the feeling that things were inflating and there was no way you could stop it.'

Besides waving a gun at anxious gold owners, there was one other to stop their speculation that the Dollar was about to collapse: fix it up with higher interest rates. Volcker took US rates to 19%. Real US interest rates shot above 9% per year.

That stopped the great gold speculation dead in its tracks. It also destroyed long-dated bond prices, but no one wanted them anyway. US Treasury bills were mocked as 'certificates of confiscation'. Raising the yield paid by new bond issues meant the US government could at last go the bond market for fresh finance once again.

The Fed kept US interest rates at double-digits until Sept. 1982. Inflation began to sink. Gold stabilized around $400 per ounce. As Volcker's medicine worked its way through the economy and inflation continued to slow gold tipped lower again. During Volcker's reign at the Fed, real US interest rates averaged 4.40%. Gold just couldn't compete. It pays you nothing, remember.

But when the Fed, the Bank of England, ECB in Frankfurt and the Bank of Japan are only willing to pay you less than zero, gold is sure to attract fresh 'safe haven' investors.

There's nothing to celebrate here, of course. The grinding destruction of global monetary values can only end badly.

Gold may simply allow a handful of anxious investors their chance to preserve a little wealth through the turmoil, ready to buy productive assets at rock-bottom prices in the aftermath.

Adrian Ash is head of research at BullionVault.com, the fastest growing gold bullion service online. Formerly head of editorial at Fleet Street Publications Ltd he is also City correspondent for The Daily Reckoning in London, and a regular contributor to MoneyWeek magazine.