What Drives the Price of Gold?

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Writing for Investopedia, author Jean Folger takes a look at what factors have been driving the price of gold, which is currently trading at record highs.

Central Bank Reserves

Central banks hold paper currencies and gold in reserve. The World Gold Council has stated that central banks have recently become net buyers of gold, the first time this has happened in decades. As the central banks diversify their monetary reserves – away from the paper currencies they’ve accumulated and into gold – the price of gold rises. Many of the world’s nations have reserves that are composed primarily of gold, including the United States, Germany, Italy, France, Portugal, Greece and the Euro area. China has publicly sated that they would like to acquire at least 6000 tonnes of gold

Value of the U.S. Dollar

The price of gold is generally inversely related to the value of the United States dollar: a stronger U.S. dollar tends to keep the price of gold lower and more controlled; a weaker U.S. dollar is likely to drive the price of gold higher. This is because people have a tendency to invest and trade in dollars when the dollar is strong. During times of economic uncertainty and when the dollar is weak, however, people prefer to invest in gold. The massive debt and money printing in the US indicates that further devaluation of the dollar will continue for the foreseable future, thus driving the price of gold higher.

Worldwide Jewelry and Industrial Demand

In 2010, jewelry accounted for approximately 54% percent of gold demand, which totaled 3,812 tonnes, according to the World Gold Council and The London Bullion Market Association. India, China and the United States are the largest consumers of gold for jewelry in terms of volume. Another 12% of demand is attributed to medical and industrial uses for gold, where it is used in the manufacturing of medical devices like stents and precision electronics like GPS units. Gold prices can be affected by the basic theory of supply and demand: as demand for consumer goods such as jewelry and electronics increase, the cost of gold can rise.

Wealth Protection

During times of economic uncertainty, as seen during the recession of the late 2000s, more people turn to investing in gold because of its enduring value. Gold is often considered a “safe haven” for investors during uncertain times. When the expected or actual returns on bonds, equities and real estate fall, the interest in gold investing increases, driving up its price. Gold can be used as a hedge against currency devaluation, inflation or deflation. In addition, gold is viewed as providing protection from political instability, as evidenced by the recent unrest in the Middle East and North Africa (MENA), which may be partly responsible for gold’s recent rally to new highs.

Gold Production

Major players in worldwide gold mining include China, South Africa, the United States, Australia, the Russian Federation and Peru. The world’s gold production affects the price of gold, another example of supply and demand. Gold mine production increased by about three percent in 2010 to about 2,652 tonnes. Despite this small increase, however, gold mine production has been in a decline since the early 2000s. One factor is that all the “easy gold” has already been mined; miners now have to dig deeper to access quality gold reserves. The fact that gold is more challenging to access raises additional problems: the miners are exposed to additional hazards, and the environmental impact is heightened. In short, it costs more to get less gold. These add to the costs of gold mine production, resulting in rising gold prices.

The Bottom Line

We have long been, and will likely continue to be, enamored by gold.  The demand for gold for wealth preservation and portfolio protection, the amount of gold in the central banks’ reserves, the value of the U.S. dollar and the desire to hold gold as a hedge against inflation and currency devaluation, all help drive the price of gold, one of the world’s precious metals.

BMG Bullion President and CEO, Nick Barisheff, recently gave a speech at the Empire Club in Toronto, where he talked about the irreversible upward drivers for gold and his outlook for the market in 2011. To view the transcript of Gold Outlook 2011: Irreversible Upward Pressure And The China Effect .