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B. Venkatesh

NEWSPAPERS carried a report that gold prices rose sharply on Thursday, September 25, primarily because OPEC decided to cut crude production. What could be the possible linkage between crude oil and gold prices? When OPEC cuts production, crude price moves up. This will increase the input cost for companies using petroleum products as intermediate goods. As a follow-up action, these companies will hike their product prices to protect their margins. If all companies follow suit, the country that imports crude oil will witness increase in general price levels.

Such an increase in the price of goods and services because of a jump in input costs is called cost-push inflation. When inflation rises, stocks and bonds typically decline in value. Why? Banks may have to pay higher interest to the depositors to compensate for the rise in price levels. In turn, banks, to protect their margins, may demand higher interest on loans to companies. Since bond prices and interest rates are inversely related, bond prices will decline if interest rates move up.

Similarly, stock prices typically decline when inflation increases. This is because the quality of earnings during high inflation is perceived to be lower. So, investors tend to give lower price-earnings multiple to stocks during this period. With stocks and bonds likely to move down, investors are left with few investment avenues. Now, gold is typically considered a hedge against inflation. This means that gold price rises if inflation increases. Perhaps, in anticipation of a possible decline in stocks and bonds due to the OPEC cut, investors started demanding gold on Thursday. The spurt in demand may have led to higher gold prices.

The link suggested above may seem tenuous, considering that we are rationalising a one-day movement in crude prices. But, remember, sentiment moves asset prices. And gold is no exception.

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