This time the increase in the price of gold could be sustainable
There is a high probability that the recent rise in the gold price has been in response to inflationary fears. If this is the case, then the price of gold could rise substantially in the short to medium term and we are in a bona-fide gold bull market. However, there is a rumor that the Bank of England may cancel the balance of its bi-monthly gold auctions. If that is indeed true, and if that is what has caused the gold price to rise, then the rally should peter out soon after an announcement is made.
Perspective

In 1999, the gold price jumped because of the Washington Agreement. When the European Central Banks announced their decision to limit the amount of gold available for lending, and put a cap on the amount of gold that they would sell in the following five years, the market panicked. Gold spiked from $255 an ounce to over $325 before falling back.

Since then there have been only two rallies that resulted in noteworthy price increases: February 2000, when gold moved from $283 to $310, and again in June, from $272 to almost $292. However, on balance, the gold market has been fairly monotonous, declining from $290 an ounce in the beginning of 1999 to $260 an ounce by the first quarter of 2001. This 10% decline in the gold price was due to the 12% increase in the dollar exchange rate during the same time - nothing more, nothing less.

Lease rates
In the last week of February this year something else started happening, something that had not occurred since mid 1999 and could portend gold’s future to some extent. In 1999, 1-month gold lease rates started moving up dramatically from just over 1% in June and peaked at almost 10% after the Washington Agreement was announced in September. This dramatic increase in lease rates (essentially the interest rate charged on gold loans) indicated that there was a substantial short-term demand for physical gold that could not be met unless the price increased. And so the gold price did increase, to over $325 an ounce.
Since then, with one short-lived exception, the short-term lease rate has not shown any significant activity until February this year; this time rising from just over 1% to more than 6% by March 9th . During “peaceful” times, when the gold market is about as exciting as watching paint dry, 1-month lease rates usually hover around 1%. Since February 23rd , the 1-month lease rate has averaged over 2.5%. This is at least 100% above the typical gold lease rate and again indicates very strong demand for physical gold. But why?

This time could be different
I will probably only understand next week, what happens this week, but in lieu of hindsight I will attempt a prognostication. What drove the gold price up in 1999 was a classic short squeeze; gold had to be bought in a hurry. What is different this time, is that there is no indication of a short squeeze. Instead, there is the fear of inflation. Traditionally gold is the barometer of the financial world and a leading indicator for inflation, in any currency. It appears as if the yellow metal is fulfilling its task with pinpoint accuracy yet again.

Rate Cuts
The gold price jumped up $4 an ounce on May 16th , the day after Alan Greenspan announced yet another 0.5% cut in interest rates. Greenspan has cut the Federal Funds Rate by 2% since January from 6% to 4% and the Discount Rate by 2.25% from 5.75% to 3.5%. This indicates several things.

Bad news!
Greenspan must be really, really concerned about the US economy to cut rates so aggressively. That cannot bode well for the US stock market, bond market or the US dollar.

Inflation
Last year the money supply in the US, as measured by M3, grew more than 9% and that was while the Fed was raising interest rates. This year alone, the money supply has increased by 4.34%, which is already over 10% on an annualized basis. Alan Greenspan’s easy money policy, in addition to historically high oil, gas and electricity prices, and an increasing wage cost index, are surely inflationary.

Further evidence for inflation comes from the fact that even though the Federal Funds Rate and the Discount Rate have been cut drastically this year, the yield on 30-year US Government bonds has actually increased. The bond market is telling us in no uncertain terms to watch out for inflation.

The market is working against the Fed
This also works against Greenspan’s attempt to boost the US economy with lower interest rates, since the market is not allowing medium to long-term interest rates to drop. In effect, the only consequence of Greenspan’s interest rate cuts is to boost the profit margins of the banking sector.

Deflation
A deflationary push could come from the evaporation of savings if the stock market crashes. My suspicion is that we will have a severe stock market correction at some point; however, if Greenspan senses a deflationary threat he’ll know exactly what to do… Pump more money into the system! Therefore, even if we do experience a short period of deflation, it is likely to be followed by even worse inflation than what we would otherwise have had.

The end of the bear market for gold
Assuming that the price of gold increased due to inflationary fears, then this would be the first time since 1996 that the price of gold has rallied for the right reason. Short squeezes, while they make for good spectator events, rarely turn out to have endurance. Inflation on the other hand, because it erodes the US dollar, could cause a sustainable increase in the gold price.

Another possibility
Unfortunately nothing is ever quite as simple, or as easy as that. I have heard a rumor that the Bank of England may cancel the balance of its bi-monthly gold auctions. If this is in fact true, it could cause the gold price to rise when it is eventually announced and unless, by coincidence, we also see a decline in the US dollar, the gold rally will surely be over shortly thereafter. Could the Bank of England be concerned about inflation?

Leaked information
In 1999, gold lease rates started climbing almost three months before the Washington Agreement was announced, indicating that a substantial amount of capital knew about the impending announcement and the impact it would have on the gold price. Lease rates have been extraordinary high for the past three months and now a rumor has surfaced that could cause the price of gold to spike once again. Coincidence?

The dollar remains the key
Either way, it doesn’t really matter because if the US dollar does not decline, any rally in the price of gold should be short lived and when the dollar does decline, the price of gold should rally regardless of what the Bank of England decides to do.
Worldwide inflation

Of course, if there is worldwide inflation, or even just the threat of worldwide inflation, then we could see a sustainable rally in the gold price against many currencies. Under such circumstances the gold price would increase even if the dollar exchange rate did not change appreciably. This may in fact happen; we have decreasing interest rates in both Europe and North America, and we have historically low interest rates in Japan. These economies make up the bulk of the world’s GDP.

Furthermore, a slow-down in the US economy could have ripple effects throughout the world. In order to mitigate the effects of a US downturn, many countries may stimulate their own economies with an increase in money supply, thus essentially creating worldwide inflation.

A personal note
I am biased and I have been nervous about the US dollar for a long time. My gut feeling is that the recent rise in the gold price is due to the threat of inflation and is pointing to future weakness in the dollar. It appears to me that the bear market is over and the bull market in gold has already begun.