After an historic twelve-year bull run, a lot of investors were surprised by the basically flat gold price last year, particularly since the global economic recovery remained anemic at best.

Global gross domestic product grew by just 3.1 percent based on the most optimistic forecast currently available. Meanwhile, the Organisation for Economic Co-operation and Development reports that its 34 developed world members managed to grow their collective economies by just 1.3 percent.

Also last year, the US Congress and the White House struggled for months to work out a compromise deal on the so-called “fiscal cliff;” Japan slipped back into a recession; and European leaders continued to deal with the fallout of years of profligate spending by its peripheral economies.

Given that backdrop, it’s hardly surprising that many investors were caught flat-footed by the price plateau on which gold has been stuck for more than a year:



But a number of factors have been working against gold recently, most of which will likely remain in play throughout 2013.

The greatest headwind for gold prices—and most other commodities priced in US dollars—has been the trajectory of the US greenback.

As you can see from the chart below, gold prices and the US dollar have an inverse relationship; gold declines as the dollar moves higher and vice versa.



Battling the Greenback

In addition to its status as a safe haven currency, the dollar has been riding an updraft created by a seeming race to the bottom of other currencies.

Despite our own bout of quantitative easing, the massive campaign of yen devaluation the Japanese have embarked on has made the American greenback much more appealing. Since the middle of 2012, the euro has also been losing ground against the dollar, even though bailout payments to Greece and other European nations are theoretically “sterilized.”

The situation hasn’t escalated into a currency war yet. However, with a number of countries competitively devaluing their currency to make their own exports more attractive and stimulate growth, it has the potential to get dicey particularly since the Japanese are involved.

Given the tight control the People’s Bank of China exerts over its own yuan, we haven’t seen much movement in the Chinese currency recently. That said, the Chinese and Japanese have been engaged in an escalating diplomatic battle over political supremacy in Asia.

As China’s economic influence has grown, it has been working to project that power across much of Asia, putting it into direct conflict with Japan’s own diplomatic agenda and heightening tensions between two powers which haven’t had much love, or respect, for each other since World War II.

The current conflict over the Diaoyu Islands, located about 170 kilometers off the northwest tip of Taiwan and 410 kilometers southwest of the tip of the Japanese archipelagos, is an excellent case in point.

The ownership of the islands has been in dispute for decades, as both China and Japan claim sovereignty over them. While the islands are uninhabited and of little value, rich fishing grounds lie in their proximity and it is believed that oil might lurk beneath the island formation.

For months, the diplomatic battle over the islands has been steadily escalating, first with the Japanese claiming to have bought the islands from a private owner to the Chinese sending a fleet into the water surrounding the islands then buzzing the area with fighter jets. Japan is now trying to get the islands registered as a World Heritage site, as a part of Japan, which could form the basis of a claim of ownership.

Because of heightening tension between the two Asian powers, it’s not beyond the realm of possibility that the Chinese will attempt to dull the export edge the Japanese are gaining as a result of their yen devaluation with a devaluation of its own.

If that occurs, the US dollar will really take off, because other emerging market nations will likely have to resort to their own devaluations to maintain their respective growth rates.

The Policy Conundrum

American monetary policy has also been a major influence on the price of gold, particularly since it has become clear that there is a growing divide between the hawks and the doves on the Federal Open Market Committee (FOMC). Recently released committee minutes have revealed that a number of its member’s have been strenuously pressing their case for ending the Fed’s program of supports sooner rather than later.

For instance, while James Bullard, president of the Federal Reserve Bank of St. Louis, doesn’t get a vote in the committee as a rotating member, he’s been very vocal about the fact that he opposes any new asset purchases and has had grave misgivings about the impact the third round of quantitative easing (QE3) will ultimately have on the economy.

Esther George, president of the Federal Reserve Bank of Kansas City, has also been making hawkish comments in the media, the main gist of which has been that interest rates are too low but borrowing activity remains muted.

So while the doves still rule the FOMC roost, there’s enough uncertainty over monetary policy that gold buyers are likely sitting on the sidelines.

That perceived hawkishness has also helped to push up Treasury yields, with the 10-year yield now over 2 percent and at its highest level in nearly a year, as the markets essentially front-run the perceived direction of Fed policy. The 30-year is now yielding 3.2 percent.

Given the improving yields on risk-free assets, buying interest is moving from gold and back into Treasury bonds.

Down, But Not Out

While headwinds will remain in place, I look for gold to regain its upward bias as 2013 progresses. For one thing, I continue to look for inflation to pick up in the coming months.

While the US government continues to claim that inflation here remains relatively flat based on its own statistics, practical experience tells us that’s not really the case.

Gasoline prices are once again on an upward march, now averaging $3.75 a gallon. Food prices have skyrocketed and are projected to rise between 3 percent and 4 percent this year as well. Over the past three years, the cost of everything from childcare and prescription drugs to vegetables and electricity has risen.

While the government argues that the rate of inflation is currently running at less than 2 percent annually, the average consumer can tell you that it’s a lot higher. That disparity is largely intentional.

Over the years, the government has made significant changes to the methodology used to compile its inflation statistics. When the consumer price index (CPI) was first created, it tracked a fixed basket of goods and services with an eye towards maintaining a constant standard of living and included items like food and energy as a matter of course given their necessary nature.

Over the years, though, the methodology used to collect the data has been changed to account for factors such as consumer substitution. Some components are excluded altogether, such as food and energy, from the government’s preferred measure given their “volatility.”

The website ShadowStats.com tracks the consumer price index has it would appear using the government’s methodology that was in place in 1990. As you can see from the chart below, which appears here with their permission, using the old methodology inflation would be running closer to 5 percent.



I don’t want to come off as a conspiracy-minded crank, so let me tell you why I’m pointing out the changes in the government’s methodology over the years.

My main point is that historically, gold prices have shown a greater correlation to the real pace of inflation rather than the US government reported CPI. A number of theories have been put forth to explain that relationship but I, for one, believe the best explanation is simply that those buying gold are basing their decision on real world experiences rather than on government reported data. If that relationship holds true, we should see gold resume its upward climb.

My broader point is that all government-issued statistics—not just those out of emerging market countries such as China—have to be taken with a grain of salt.

Since the government bases its cost of living boosts for a number of programs such as Social Security and federal worker pay on the CPI, it’s in its best fiscal interests to keep a lid on inflation perceptions by any means possible. On top of that, there’s the base consideration that inflationary politicians tend to not be very popular come reelection time.

Regardless of what the government characterizes as the level of inflation, the reality of inflation will serve to push gold upward as higher consumer prices sink in.

That’s especially true if the growth outlook here in the US and the rest of the world continues to improve and inflation becomes a greater baseline concern.

On top of that, central banks around the world are showing a growing appetite for gold. According to data from the World Gold Council, central bank buying shot up by 17 percent year-over-year in 2012 as they accumulated 535 tons of gold.

Central banks continue buying gold, adding 535 tons to their hordes last year according to data from the World Gold Council. That’s a 17 percent jump over 2011’s buying levels and marks the third year of net positive central bank gold demand and the largest volume of net purchases since the mid-1960s (see chart below).



Those purchases don’t reflect the estimated 250 tons worth of gold purchases by the People’s Bank of China, which is largely deduced from estimated domestic mine production and gold import statistics, since the government there doesn’t officially report its gold holdings.

Much of that accumulation is likely being driven by the desire of global central banks to diversify away from the US dollar, although the motivations behind that impulse vary from nation to nation. Regardless of the reasons, there’s no denying that central banks are eager to add to their gold stocks.

The Long and the Short

Given the huge run that gold prices have taken over the past decade and more, it’s no surprise that gold hit a consolidation period last year, particularly as investors around the world began to gradually come out of the crisis mode they had maintained for several years.

But despite the headwinds still facing gold prices, there are plenty of reasons to look for them to move higher, even if at a slower rate than we’ve grown accustomed to.

I continue to take a positive view of global gold producers; see this issue’s Stock Spotlight for my favorite gold plays.