The speed of correction of gold prices in response to a shock is comparatively slow. Deviations of thegold price from its long run equilibrium can be significant, long-lasting and take years to fully erode

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In the short run previous momentum in the price of gold (as captured by the two previous quarters‟ price

movements) is a significant factor. If the price of gold rises by 10% in the two previous quarters this willraise the current price by 3.3%, all other things equal

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 The effective exchange rate was found to have the strongest contemporaneous statistical relationshipwith gold, with a rise in the value of the US$ pushing down the price of gold in US$. A 10% appreciationof the US$ reduces the price of gold by 8.4% (this is broadly in line with the elasticity estimated by theIMF noted in section 2.4 above)

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 The real interest rate captures the opportunity cost of holding gold relative to other risk free assets whichpay a return. As expected, a rise in the real interest rate reduces the price of gold; the equation suggeststhat a 100 basis point fall in the real interest rate will result in an initial 1.5% rise in the price of gold

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 The credit default premium captures the risk environment within the financial system. As a result this termis relatively unimportant in normal times (as the risk premium does not move very much) but in times ofcrisis it is a significant driver of the price of gold. A 100 basis point rise in the premium will increase theprice of gold by 4.4% in the following quarter

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 As with the credit default premium, the US monetary base is a relatively unimportant determinant ofmovements under normal economic conditions but in more recent times it has been a significant driver ofthe gold price.

11

A 10% point increase in the growth rate of the monetary base results in a 1.4% rise in

Doing this confirms that the recent strong rise in gold prices has been the result of a complex of short-runshock factors:

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 The depreciation of effective dollar exchange rate

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 The recent financial crisis, which raised financial stress levels

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 Most

recently the Federal Reserve‟s quan

titative easing policy, which has raised fears over medium terminflation

The different scenarios we investigate are as follows:

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 The Oxford Economics baseline scenario featuring a steady economic recovery, moderate inflation andgradual normalisation of financial conditions

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 A deflation scenario featuring a massive financial shock leading to renewed recession and fallingconsumer prices

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 A stagflation scenario featuring higher inflation and interest rates but weaker growth than in the baseline

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 A high inflation scenario featuring a wage-price spiral and lax monetary policy pushing inflation to doubledigits and ultimately leading to a sharp monetary tightening and recession