Gold Forecast 2012 and Beyond: Why Prices Could Surge

He also predicted that gold could eventually trade at $2,400 per ounce based on fundamentals and $4,000 per ounce if investors overreact.

His forecast on gold and inflation, however, haven’t panned out so far in 2012.

Paulson’s assumption was that hard assets like gold will surge because the Federal Reserve has flooded the U.S. financial system with money since September 2008.

Intuitively, it makes sense; if you increase the quantity of money in circulation and keep the quantity of gold mostly constant, the price of gold should increase.

The flaw in this logic, however, is that the quantity of money in the financial system, excluding excess reserves, has not in fact dramatically increase. As a result, consumer inflation and asset inflation have also remained relatively tame.

Excess reserves are money banks keep in the central bank beyond what they are required by regulation to keep.

Data from Federal Reserve, chart made using Microsoft Excel

Data from Federal Reserve, chart made using Microsoft Excel

Chart from Richard Koo of Nomura Research Institute

But, banks are only keeping large amounts of excess reserves by choice, meaning they could flood the U.S. financial markets and economy if they choose to do so.

If they do, inflation may very well hit double-digits and gold may very well trade $4,000 per ounce, as Paulson had forecasted in 2010.

The million-dollar (or multi-billion dollar, in Paulson’s case) question, therefore, is if bankers will in fact lend out their excess reserves

Experts are sharply divided on this issue.

Economist Paul Krugman of Princeton University thinks “big increases in the monetary base don’t matter” if banks hoard cash, as they currently are.

Economist Greg Mankiw of Harvard University believes “monetary base is a pretty uninteresting economic statistic” if Federal Reserve entices banks to keep excess reserves by paying interest on them, which it currently does.

However, Bill Tedford, an investment professional with Stephens Inc., an Arkansas-based financial service company, believes inflation tracks monetary base in the long-term.

He calculated that monetary base minus economic growth closely matched consumer inflation from 1967 to 2007, reported the Wall Street Journal.

Data from BLS and Federal Reserve, chart made using Microsoft Excel

The correlation between monetary base growth minus GDP growth and inflation holds well in the 1960s and 1970s. It began to break down in the mid-1980s partly because of cheap imports coming from countries like China, which kept inflation down.

Theory and history aside, the question of inflation still depends on whether bankers will ramp up lending.

“Until bankers gain more confidence in the sustainability in the economic recovery, loan growth will remain modest,” said Peter Boockvar, equity strategist at Miller Tabak, an institutional trading firm.

Boockvar said if lending surges, inflation could become a “major” problem.

But this million-dollar question may one of “when,” not “if,” because some argued that it’s only a matter of time before banks eventually lend out the money they hold in excess reserves.

With the notable exception of Japan, history indicates this is the case.

Gavyn Davies of Financial Times pointed to a study published by Bank of England Governor Mervyn King (below), which shows an “almost perfect” correlation between monetary base and inflation over a 10-year horizon.

The study examined 116 countries from 1968 to 1998.