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Fed's quest for inflation giving gold bugs a new reason to cheer

A glimmer of hope is emerging for gold bugs from something Americans haven't seen much of in quite a while: inflation.

[NEW YORK] A glimmer of hope is emerging for gold bugs from something Americans haven't seen much of in quite a while: inflation.

Sure, US consumer prices have been mostly subdued since the financial crisis - the rate of gain actually eased over the past three years, most recently because the cost of oil plunged. But crude prices rebounded last month, the dollar's rally stalled and investors who in December were unloading bullion and bracing for deflation are now stepping up bets that inflation is returning.

And it's more than just oil. Wages are rising, and Federal Reserve policy makers point to improved labour markets as a reason inflation will climb to their 2 percent target.

That would be a boon for gold, which through April was headed for its third straight annual decline. Holdings in funds backed by the metal are rebounding, and speculators are getting more bullish.

"Is runaway inflation coming back? No, but could concerns that inflation has bottomed out come back? I think it is coming back this year," Jim Paulsen, the Minneapolis-based chief investment strategist at Wells Capital Management, which oversees US$351 billion, said April 30. "That would be enough to bring interest to gold."

Since dropping to this year's low in mid-March, gold futures are up 4 per cent to US$1,187 an ounce on the Comex at 10:47 am in Singapore. The metal will increase to an average of US$1,248 this year, and reach US$1,338 in 2016, Bank of America Corp analysts reiterated in a May 1 report. HSBC Securities (USA) Inc and Commerzbank AG are also bullish.

Bullion's link with inflation dates back more than 2,000 years, with the first use of coin currency in 550 BC, according to the World Gold Council. The precious metal climbed 70 per cent from December 2008 to June 2011 as the US central bank fanned inflation fears as it bought debt and held borrowing costs near zero percent in a bid to shore up growth.

But the surge in consumer prices that many gold buyers feared never materialized, and the precious metal tumbled 29 per cent in the two years ended Dec 31. Inflation risks took another blow when crude-oil futures that topped US$100 a barrel in June slumped to a six-year low of US$42.03 in March.

The outlook began to change after Fed economists on March 18 trimmed their expectations for how quickly the central bank will raise interest rates. Before then, expectations of the first increase in borrowing costs since 2006 helped send the dollar up 22 per cent since June.

Now, the US currency has pared this year's gains, and bond investors have increased purchases of Treasury Inflation Protected Securities, or TIPS. Crude oil surged 25 per cent in April, the most since May 2009, and was at US$58.87 on Tuesday.

A gauge of inflation expectations that closely tracks gold is trading near the highest since September. Declines for US jobless claims and gains for manufacturing show why those expectations are increasing, according to Mike Pond, the head of global inflation market strategy at Barclays Plc in New York.

"We see inflation rising later this year," Pond said in an April 30 telephone interview. "There is evidence within the data that the labour market is tight enough. There is also anecdotal evidence, particularly in the retail sector. Within the construction industry, businesses are reporting that they are finding it difficult in hiring skilled labor."

Investors are returning to global exchange-traded funds backed by gold, increasing their hoard by about 4 metric tons in April, the third gain in four months, data compiled by Bloomberg show. While holdings are up just 1.8 per cent this year to 1,627.3 tons on May 1, the increase comes after a 39 percent decline in the previous two years.

To be sure, consumer prices have been mostly stable over the past several years, with a 2014 gain of just 0.8 per cent, including energy and food, government data show. The Fed's preferred inflation gauge has lingered below policy maker's 2 per cent goal since May 2012. Gold is down about 20 per cent over the past 24 months, and banks including Societe Generale SA and Goldman Sachs Group Inc. expect the declines to continue.

While bullion rose earlier last month as economists pushed back their outlook for when the Fed would start raising rates, prices fell last week after policy makers meeting April 28-29 failed to signal they were any less eager to act. The central bank wants to give the economy a boost to spark more inflation. Higher rates drive investors to favour assets that pay interest, including new bonds, curbing the appeal of gold, which generally offers returns only through price gains.

"As soon as policy rates go up, then bond yields go up, and the opportunity cost of holding gold goes up," said Frances Hudson, a global thematic strategist who helps oversee US$383 billion at Standard Life Investments in Edinburgh. "If you look at all the influences, whether they're economic or physical supply or demand, there doesn't seem to be anything that's going to be a very strong, upward motive for gold."

Money managers have still been getting more bullish on the metal. Net-long positions in US futures and options climbed 3.7 per cent in the week ended April 28 and have almost doubled from this year's low in March, government figures show.

Because inflation has been so low, even small gains for prices will help to boost gold in the months before the Fed raises rates, according to Jeff Sica, president of Circle Squared Alternative Investments in Morristown, New Jersey.

"Inflation expectations are heading higher, and it's playing into the yield curve," Jim Russell, a Cincinnati-based portfolio manager at Bahl & Gaynor Inc, which has about US$14 billion under management and advisement, said by phone April 29. "It puts in a floor for gold and establishes a lower boundary that help prices move higher. Probably nothing spectacular, but still will be supportive."