For centuries, gold has played a central role as a store of value and a financial asset. However, its price is influenced by a number of key factors, not least interest rates. 

What is the relationship between interest rates and the price of gold today? And is this relationship constant? This question has long puzzled economists, especially under the gold standard. The dynamics influencing the price of gold have become clearer since the liberalisation of the gold market in 1971. This article explores the relationship between the interest rate and gold.  

Who sets the interest rate? 

Nominal interest rates are set by central banks. Rates thus influence the cost of borrowing and the return on savings, enabling central banks to encourage saving or consumption. Real rates, on the other hand, take inflation into account and are calculated as follows: nominal rate - inflation rate.  

In the long term, central banks aim to stabilise inflation at around 2%, which means that the nominal rate often fluctuates around this threshold. The real rate therefore often acts as a means of regulating savings or consumption, and therefore inflation. Furthermore, investors often consider the real rate to be the ‘real rate’ of return on savings, i.e. the rate at which capital grows faster than the loss of purchasing power caused by inflation. 

Why do real rates affect gold? 

By its very nature, gold is a non-yielding asset: it pays no interest and no dividends. When real interest rates rise, the opportunity cost of holding gold increases, because investors can obtain higher returns by investing their capital in bonds or other fixed-income assets. Gold becomes ‘less attractive’. Conversely, when real interest rates fall, gold becomes more attractive because it is seen as a hedge against currency devaluation.  

Furthermore, a reduction in the real rate can be induced either by a rise in inflation, or by a reduction in rates by central banks. If prices are rising faster, high inflation tends to erode the real returns on financial assets. Gold is therefore seen as protection against a loss of purchasing power, as we have seen in recent years.  

Similarly, central bank decisions, such as whether to cut or raise key interest rates, have a direct impact on nominal rates and, consequently, on real rates. For example, an accommodating policy, with low interest rates, tends to boost gold prices. 

What is the real link between interest rates and the price of gold?  

A number of academic and financial studies have explored the link between gold prices and interest rates. In 2011, a study by Wang, Lee, and Thi showed that real interest rates and the price of gold are strongly inversely correlated. In other words, a fall in real interest rates leads to a rise in the price of gold.  Between 1970 and 2010, every 1% fall in real interest rates corresponded to an average 10% rise in the price of gold! 

Source : 10-Year Real Interest Rate (REAINTRATREARAT10Y) | FRED | St. Louis Fed

For example, during the financial crisis of 2008, when the Fed reduced its key rates to almost zero, real rates became negative. The price of gold soared by 56% between 2008 and 2011, reaching an all-time high of over $1,900 an ounce in September 2011. 

The reverse situation is more or less true. For example, in the 1980s, under Paul Volcker at the Fed, aggressive interest rate hikes to control inflation led to a dramatic fall in the price of gold. It fell from $850 an ounce in 1980 to around $300 in 1982. Similarly, the fall in real interest rates in the 1990s was not accompanied by a significant rise in the gold price. It was not until the early 2000s that the fall in real interest rates was accompanied by a massive rise in the price of gold.  

A relationship that benefits the gold price? 

The last few years offer an illuminating example of the dynamic between gold and interest rates. With the outbreak of COVID-19, central banks around the world cut their key rates and launched quantitative easing (QE) programmes. With real rates turning sharply negative, the price of gold hit a new record high of over $2,000 an ounce in August 2020. 

But in 2022-2023, in response to galloping inflation, the Fed adopted a restrictive monetary policy by rapidly raising its key rates. This historic increase in real interest rates led many investors to anticipate a sharp fall in the gold price.  However, gold showed some resilience, settling at around $1,800 to $1,950 an ounce, due to persistent demand from central banks in emerging countries. 

As a result, the link between gold and the real rate is more likely to hold when the real rate is falling than when it is rising. One reason for this would be that, despite the fact that gold becomes less attractive when rates rise, the cost of producing gold rarely falls and mining companies have to keep prices high in the face of demand.  

What other factors influence the price of gold? 

Many other factors influence the price of gold. For example, gold is generally quoted in US dollars (USD). This means that a fall in the value of the dollar makes gold cheaper for investors in other currencies, stimulating demand and leading to a higher gold price (the dollar has devalued).  

What's more, the gold market remains a commodity market. Gold is both a financial asset and a raw material used in jewellery and industry. As a result, demand in these sectors can moderate the impact of interest rates on its price. As we have pointed out, a rise in interest rates increases the cost of capital, and therefore the cost of producing gold, which limits the downward potential of the price.  

Finally, central bank policies influence the price of gold. Gold purchases by central banks, particularly in China and Russia, also influence market dynamics. Central banks are holding on to gold in the face of geopolitical risks.  

Gold, a hidden currency? 

Gold has a unique quality: it has a high value, making it possible to raise large amounts of capital with small physical quantities. A common mechanism in international finance is interest rate arbitrage, which involves buying the currencies of countries offering high rates while selling those of countries with low rates. This process often amounts to investing in the assets of high-interest-rate economies while withdrawing from low-interest-rate economies. 

When a country's interest rates fall, this can lead to capital flight as investors seek better opportunities elsewhere. This is sometimes reflected in increased interest in ‘foreign’ assets perceived as safe havens, such as gold. Consequently, a fall in interest rates can indirectly stimulate demand for gold as a means of diversifying investments and preserving wealth in times of low returns. 

In the same way that a fall in interest rates increases the value of assets issued in the past, a fall in interest rates will increase the ‘present value’ of gold.  

Psychological and behavioural factors 

In addition to traditional financial mechanisms, investors are also influenced by psychological factors when making their gold-buying decisions. Although speculative bubbles are very rare in gold, it is possible for a sharp rise in the price of gold to lead to a lasting asymmetry between market fundamentals and the price of gold. In the 1980s, runaway inflation and frenetic demand for gold destabilised the relationship between interest rates and the gold price.  

In times of economic uncertainty or crisis, the fear of currency devaluation often pushes individuals and institutions to turn to gold, even if the economic fundamentals have not yet changed. This phenomenon of anticipating falling interest rates, in economies that are sometimes over-indebted, means that investors do not seriously consider the possibility of a lasting rise in interest rates. 

Geopolitical crises also reinforce this behaviour. During the Cold War, for example, or when there were tensions between major economic powers, gold often served as a refuge from the uncertainties associated with sanctions, trade disruptions or currency devaluations. Rising interest rates to combat inflation, combined with the outbreak of conflict, could therefore have an ambiguous effect on the gold price.  

Conclusion 

Falling interest rates, particularly real interest rates, are having a profound effect on the price of gold. By making fixed-income assets less attractive and encouraging potential inflation, these falls reinforce gold's role as a store of value. Lower real interest rates reduce the value of money, thereby increasing the value of gold.  

However, it is crucial to consider all market dynamics and external factors for a complete analysis. The yellow metal remains a valuable indicator of economic health and investor expectations. Any movement in rates and inflation must therefore be interpreted globally, taking into account both investor expectations and the exact state of the monetary cycle.