Are Gold and RBI confusing you?

It is obviously tough to drive a car on an unknown highway when you see arrows pointed at opposite directions. All you can do then is to rely on your intuitions! Unfortunately investors in India hoping to have a long wealth building ride are in a similar conundrum. To add to market volatility, the conflicting economic signals are making it all the more difficult to take calculated risks. 

The RBI in its Monetary Policy review today took a stubborn stance to keep interest rates unchanged. Needless to say it has policy makers coercing it to lower rates for months now. In addition, falling commodity prices, particularly oil, make the central bank's anti inflationary stance seem foolish! Moreover, even the manufacturing index has been moving up, showing signs of economic recovery. 

Why then would the central bank want to keep rates stiff? Why not offer businesses and consumers easier access to credit so as to boost investment and consumption? We will come to that in a bit. First let us see what gold has to say. 

The only asset class that has had inflation hedging properties for generations is headed lower. As much as hardcore capitalists reject the utility of gold as an investment worthy asset, central banks world over, have been hoarding the metal for decades now. In fact the Swiss central bank, which was the last one to let go of Gold Standard, wanted to keep 20% of its reserves in gold until recently. However, gold prices over the past few weeks revisited the 2012 lows. And that almost put an end to every speculation that hyper inflation remains a threat to global economy. Even the critics of US Fed's money printing policies rejected the possibility of hyper inflation. And therefore investors chose to dump gold rather than hold on to it as a store of value. 

Therefore the RBI's views that inflation risks are here to stay are contradicting the deflationary trend reflected in gold prices. Investors therefore have every reason to be confused about what kind of risks they should anticipate and the kind of returns to expect. If inflation is indeed set to get significantly lower, they would rather invest in stocks. On the contrary, high inflation would warrant exposure to an inflation hedge like gold. 

Well, according to us, neither is the RBI nor are gold prices wrong. For the signals being given out are nothing but temporary. The RBI is certainly not satisfied with consumer inflation remaining above 5%. Moreover, given that central banks elsewhere in the world have not stopped printing money, the possibility of excess liquidity creating asset bubbles remains. Meanwhile, the fall in gold prices over the last year needs to be seen in the context of rise in other asset classes. And even if lower commodity prices keep inflation tempered, liquidity risks will ensure that gold remains the best insurance against devaluation of currencies. 

As an investor, therefore, you would be better off not paying too much attention to these temporary economic trends. Instead focus on the long term Megatrends taking shape in emerging countries like India. These are the trends that will play out irrespective of where interest rates and gold prices head in the near term. And needless to say that they will ensure that you fetch healthy inflation adjusted returns for a very long time to come!