The relationship between central banks and gold

By Richard ZimmermanGold seems to make fresh news headlines every day, and there is plenty of active desire to know the price. Like most commodities, that price is based upon changes in the forces of supply and demand. Gold is different: First because gold production is comparatively stable and unlikely to change much in the near future, and second because the supply and demand remains very liquid, although at times very sensitive and subject to rapid changes.

Much demand for gold characteristically comes from investors and buyers of gold jewelry. Investors frequently favor gold as a store of value during times of economic stress. There is another large holder of gold deposits: Central banks in their reserves. Let's review how much gold there is in central banks and what actions to expect by those who own it.

The role that central banks play is not always clear. They exist to manage a nation's currency. They perform this function by controlling their country's supply of money and thus influence interest rates by their actions. There are other tricks they can perform (quantitative easing comes to mind) but while they continue to own vast amounts of gold holdings, they do not use the gold standard any longer. Instead they maintain gold reserves as credibility, preferring to exchange currencies with one another. Do you remember the old axiom that "money doesn't grow on trees"? It doesn't; it gets created by central banks. The gold they hold is more of a backstop, or last line of defense.

What about that central bank gold; what do they do with it? In the currently financially stressed macro environment what actions might central banks take?


Summary

Even without the gold standard in force, gold still has retained an important function among central banks. It serves as a desirable backstop of last resort among global monetary reserves. Gold is exchangeable, and that quality keeps it the ultimate reserve currency, even among central banks. Decisions made by central banks influence money supply, relate to interest rates moves, and economic growth. Investors are now seeing financial stresses that make gold a desirable investment, even among other central banks. For now, expect European central banks to hang on to the gold they have. Meanwhile the entire available supplies of gold in the world, including all that is held privately is nothing when compared to the amounts of paper gold and underwritten risk in the global financial derivatives markets. But that's another story.