How Could Shift In Monetary Regime Affect The Gold Market?

Some economists, including San Francisco Fed President John Williams, have recently suggested raising the FOMC’s 2-percent inflation objective or implementing monetary policy through alternative frameworks, such as price-level or nominal GDP targeting. It is not a mere academic debate, as the Bank of Japan increased its inflation target in a sense, as it committed “itself to expanding the monetary base until the year-on-year rate of increase in the observed consumer price index (CPI) exceeds the price stability target of two percent and stays above the target in a stable manner”. What are these frameworks and how could they, if implemented in the U.S., affect the gold market?

When President Nixon closed the gold window in 1971, ending the gold standard, the central banks were left without a nominal anchor for monetary policy. So, at the beginning, they adopted money supply targeting. That approach was based on the constant growth in the money supply which was supposed to translate into stable inflation rates. However, as the velocity of money was not constant, monetary targeting failed to generate stable prices. This is why in the 1990s and 2000s many central banks adopted inflation targeting. In such a framework, central banks have explicit target inflation rates for the medium term which is publicly announced (readers interested in the topic should read this study where they find a more elaborate definition of inflation targeting). The idea is that when inflation is higher than targeted, the central bank hikes interest rates, and reduces them when inflation falls below the target. But in the current environment of ultra low interest rates, there is a zero-bound problem. This is the primary reason to raise the inflation target from the current 2 to, let’s say, 4 percent, as some economists suggested. Higher inflation targets would increase the nominal interest rates (as investors would demand some inflation premium), allowing central banks to cut interest rates more when a recession occurs, and thus ease the zero-bound constraint.