Inflation, Gold, and Iran

No sooner had the Federal Reserve cut interest rates than the inflation hawks began squawking that Bernanke and company had blown it and inflation was sure to worsen. And not without some plausible reasons.

For starters, a pair of market-based measures of inflation expectations did worsen. The day after the half-percentage-point Fed rate cut on September 18, the difference between regular and inflation-indexed Treasury bonds topped 2.6 percent for the first time in more than year, investment firm Goldman Sachs notes. The difference between the two can be thought of as the inflation rate investors are expecting in the future.

What's more, gold—often seen as an inflation hedge—vaulted higher, hitting $732 per ounce as I write this. That's its highest price since early 1980 and up more than 50 percent from a year ago.

And then you have the tumbling dollar. While respecting the wisdom of Mr. Market, there are even better reasons to think higher inflation is not in our future. Here is how Goldie sees it and then my take:

1) Since their peak on September 20, the difference between nominal and inflation-indexed Treasury yields from five to 10 years in the future has come down to 2.57 percent from more than 2.6 percent. This is probably still higher than Fed officials would like, but not in truly worrisome territory.

2) Although dollar weakness and inflation are certainly correlated—dollar weakness raises the threat of higher import price inflation—they are far from the same thing.

3) Consumer inflation expectations remain well-anchored. In particular, median five-to-10-year inflation expectations as measured by the University of Michigan's survey remain well within the 2.9 percent to 3.2 percent range of the past two years. Professional forecasters are also sanguine, with 10-year inflation expectations of 2.4 percent, slightly lower than the 2.5 percent expectation that has prevailed over most of the past decade.

My take: I find the surge in gold particularly noteworthy since many economists I know—particularly of the supply-side variety—have been pointing to the rising gold price as an almost sure-fire indicator that inflation is headed sharply higher. But I think the real message of gold today, as it has been since 2001, might just be that we live in a world of heightened risk, and gold has always been the ultimate safe-haven investment.

The most recent surge in gold prices comes at the same as time there's been more talk—particularly by the French—of taking military action again Iran if it doesn't abandon its efforts to build a nuke. (Interestingly, the last great gold surge happened during the Iranian revolution in 1979.) Plus, there have been unconfirmed reports of a secret Israeli airstrike on a Syrian nuclear facility more than two weeks ago.

After falling throughout the 1980s and 1990s, gold bottomed in 1999 and then began a steady march higher in early 2001. You could interpret that 20-year drop as a sign not only of diminishing inflation but also that the world was becoming a safer place, with less threat of a nuclear war. Likewise, the rise since 2001 and 9/11 is a sign that the world is becoming a dangerous place again.

The fear factor is also at play with stocks. The market's current price-to-earnings ratio is right at its historical average, a strangely subdued state given fat corporate profits and a lengthy economic expansion. Higher gold prices? Blame Ahmadinejad, not Bernanke.