This report is available on wellsfargo.com/research and on Bloomberg WFEC

October 20, 2009

Economics Group

Executive Summary

Gold prices have surged in recent months, which some observers claim is a clear warning thatinflation will soon turn sharply higher as it did in the late 1970s. However, other forward-lookingmarket-based inflation indicators do not support this hypothesis. Inflation indicators such as bond yields, consumer expectations and TIPS spreads have been running at fairly depressedlevels, which suggest inflation will likely remain benign.

If the spike in gold prices is not a sign of looming inflation, why are gold prices at a record high?It appears that foreign central banks may be playing a role in driving gold prices higher. After twodecades of reducing their holdings of gold, central bank purchases of the precious metal set arecord in July and anecdotal evidence suggests they have continued to buy more recently. Inaddition, the increase in futures contracts outstanding indicates that speculative activity is alsopicking up.Does the apparent attempt of foreign central banks to build up their holdings of gold indicate thatthey have “lost confidence” in the dollar? Probably not, at least not yet. Foreign central banksappear to be diversifying on a flow basis only because they remain net buyers of U.S. Treasury securities. If foreign central banks had indeed “lost confidence” in the greenback, we think they would be reducing their holdings of Treasury securities. However, indications that the UnitedStates is not serious about addressing its long-run fiscal challenges could eventually lead foreigncentral banks to reassess their willingness to continue financing U.S. government obligations.

Gold Prices as a Harbinger of Inflation

Many recall the gold price spikes of the early 1970s and early 1980s that heralded double-digitinflation months in advance. Indeed, the doubling of gold prices between late 1972 and mid-1973 was followed by a sharp increase in consumer price inflation (Figure 1). That episode in the early 1970s was simply a warm-up act for the early 1980s when gold prices surged to the unheard of price of $650/ounce in January 1980. By spring of that year, CPI inflation was running near15 percent. Today, the price of gold has been trending higher for a year, and currently exceeds$1000/ounce. Does the recent moonshot in gold prices herald another decade of runaway inflation?Between the early 1970s through the late 1990s, gold prices and the rate of inflation followed arelatively predictable path. A persistent upward trend in gold prices became a fairly reliableharbinger of high inflation. As such, investors seeking to hedge against inflation flocked to gold,pushing up the price even higher.Before we all cash in our monetary savings for prized art objects, which were used as an inflationhedge in the 1970s, let’s put the current increase in gold prices into perspective. Although theprice of gold is currently at a record level, its price changed more quickly in the late 1970s than it

The TIPS spread is the difference between the yield on a Treasury security and the yield on the Treasury Inflation-Protected Security of comparable maturity. Therefore, the spread measures the difference between a nominal yield and areal yield, and can thus be interpreted as a measure on inflation expectations.

Special Commentary

Jay Bryson, Global Economist

jay.bryson@wachovia.com

●

704-383-3518

Anika R. Khan, Economist

anika.khan@wachovia.com

●

704-715-0575

Yasmine Kamaruddin, Economic Analyst

yasmine.kamaruddin@wachovia.com

●

704-374-2992

What Is Gold Telling Us?

Gold prices surged in the late 1970s asCPI inflation shot higher.

What Is Gold Telling Us? WELLS FARGO SECURITIES, LLCOctober 20, 2009

ECONOMICS GROUP

has at present. Over the past 12 months the price of gold has risen about 50 percent, a sizeableincrease but well short of the near trebling in price that occurred between January 1979 andJanuary 1980. In real terms, the price of gold is about 50 percent below the peak that it reachedin January 1980 (Figure 2). Therefore, the inflationary signal that today’s increase in gold pricesmay be sending does not appear to be as strident as the warning sent three decades ago.

Figure 1

CPI vs. Lagged Gold Prices

Year-over-Year Percent Change, Dollar per Ounce-5%0%5%10%15%20%25%1971197519791983198719911995199920032007$0$200$400$600$800$1,000$1,200CPI, Year-over-Year Percent Change: Sep @ -1.3%Gold Spot Price, 1-Year Lag: Oct @ $1,066.02 per Ounce

Figure 2

Real vs. Nominal Price of Gold

Index, January 1980 = 10001020304050607080901001101201970197419781982198619901994199820022006$0$100$200$300$400$500$600$700$800$900$1,000$1,100$1,200Real Gold Prices: Sep @ 56 (Left Axis)Gold Spot Price: Oct @ $1,066.02 per Ounce (Right Axis)

* Real price of gold delfated using CPI

Source: U.S. Department of Labor, Bloomberg LP and Wells Fargo Securities, LLC

Moreover, we are not convinced that the current run-up in the price of gold is indeed associated with concerns about rising inflation, because other early-warning signals of inflation arequiescent at present. Consider Treasury bond yields. The high inflation rates of the early 1980sand expectations that inflation would remain elevated led to double-digit yields on 10-year U.S.Treasury securities (Figure 3). Today, however, the yield on the 10-year U.S. Treasury security iscomfortably below 4 percent. Would investors really be concerned about runaway inflation if they are willing to lend money to the U.S. Treasury for 10 years at less than 4 percent per annum?Moreover, the yield spread between the nominal 10-year bond and the inflation-protected 10 year bond, the so-called TIPS spread, is less than 2 percent at present.

If inflation is aconcern, then whyare Treasury yieldsso low?

The Fed announced in March 2009 that it would buy $300 billion worth of Treasury securities tohelp hold down long-term interest rates. Couldn’t the Fed’s extraordinary purchase programartificially reduce Treasury yields and render them useless as an inflation signal? In the absenceof the Fed’s purchases, wouldn’t Treasury yields be higher and investor concerns about inflation be more visible?Maybe, but the Fed is near the end of its purchase program. It seems that Treasury yields wouldhave already reacted to the well-publicized news that the Fed plans to wrap up its program by theend of October 2009. Moreover, the Fed’s total purchases represent only 4 percent of the$7 trillion worth of marketable Treasury securities outstanding. It does not seem likely that theFed’s actions would be able to hold down yields if investors really feared an inflationary outbreak.Moreover, other inflation indicators are not flashing red at present. There is a question in theUniversity of Michigan’s survey of consumer attitudes that measures inflation expectations overthe next five years. This measure of inflation expectation rose to nearly 10 percent in the early 1980s, but it has remained remarkably steady over the past decade or so suggesting thatconsumers do not seem to be too worried about inflation at present (Figure 4). Therefore, thehypothesis that the sharp increase in gold prices recently foretells an episode of rapidly risinginflation does not appear to be supported by other measures of inflation expectations.

Consumers’ inflationexpectationsremain wellcontained.

Another plausible idea is that the rise in gold prices is due to an increase in risk aversion. In thepast, investors have flocked to the safety of gold when they have become spooked. If risk aversion were rising, however, then why have the prices of equities, whose uncertain cash flow 2

What Is Gold Telling Us?

WELLS FARGO SECURITIES, LLCOctober 20, 2009

ECONOMICS GROUP

3characteristics make them among the riskiest of financial assets, increased so much recently?

The fall in the VIX index, which measures stock market volatility, and the narrowing of creditspreads also indicate that risk aversion is declining, not increasing.

Figure 3

10-Year Treasury Yield vs. TIPS Spread

Percent0%2%4%6%8%10%12%14%16%18%20%19701974197819821986199019941998200220060%2%4%6%8%10%12%14%16%18%20%US 10-Year Government Bond: Sep @ 3.31%TIPS Spread: Sep @ 1.77%

TIPS spread = 10 Year Govt. Bond Yield -10 Year Inflation-Protected GovernmentBond Yield

Figure 4

Inflation Expectations in Five Years

University of Michigan0%1%2%3%4%5%6%7%8%9%10%19801983198619891992199519982001200420070%1%2%3%4%5%6%7%8%9%10%Inflation Expectations in 5 Years: Oct @ 2.9%

Source: Federal Reserve Board, University of Michigan and Wells Fargo Securities, LLC

Some Central Banks Are Switching into Gold

If expectations of rising inflation and increasing risk aversion do not appear to be goodexplanations for the recent run-up in the price of gold, then what explains its increase? We believe that central banks may be part of the story. The price of gold fell to roughly $900/ouncein early July, but it has risen essentially non-stop in subsequent weeks. Interestingly, goldpurchases by central banks increased by a record amount in July (Figure 5). Although “hard” datafor central bank holdings of gold in August, September and the first few weeks of October are not yet readily available, anecdotal evidence suggests that central banks have continued to purchasegold. For example, a recent

Wall Street Journal

article noted that the Taiwanese central bank willlikely increase the

amount of gold in its foreign-exchange reserves.

Why would central banks have an interest in buying gold? Central banks have increased theirforeign exchange holding from about $2 trillion at the beginning of the decade to roughly $7 trillion at present, and the U.S. dollar comprises about two-thirds of that total. How many more dollar assets do foreign central banks need? Although foreign central banks continue to buy U.S. Treasury securities—they purchased $53 billion in the 12 months through August 2009—thepace of purchases has slowed over the past year or so. Foreign central banks are not dumpingU.S. assets, but they appear to be diversifying their purchases on a flow basis. Although central bank holdings of gold have trended lower for the past two decades, foreign central banks may be buying gold again as a way to diversify their portfolios and their purchases appear to becontributing to the increase in the price of the precious metal.

Speculators May Be Piling On

It also appears that speculators have thrown their hat in the ring and are helping to push goldprices up even higher. One measure of speculative activity is the number of futures contractsoutstanding, so-called “open interest”, on the COMEX exchange. Future contracts allow investorsto realize financial gains through price changes without taking physical possession of acommodity. The price of gold and the amount of open interest have been trending higher over thepast few years (Figure 6). Since early September open interest has increased by 165,000contracts, the largest six-week rise in about 10 years. Although commercial accounts (i.e., endusers of gold) may be increasing the number of future contracts they buy to hedge against further

The S&P 500 index is up more than 60 percent relative to its bottom in March 2009.

Perris Lee Choon Siong, “Taiwan Ctrl Bank Gov: Can Study Increasing Gold in FX Reserves”, the

Wall Street Journal

,Oct. 13, 2009