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Central Banks and Gold Liquidity

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To add liquidity to the gold market, many central banks provide gold to bullion banks and commercial banks with proprietary gold trading desks. According to the World Gold Council, bullion banks are investment banks that function as wholesale suppliers dealing in large quantities of gold. All bullion banks are members of the London Bullion Market Association.

Bullion banks differ from depositories in that bullion banks handle transactions in gold and the depositories store and protect the actual bullion. For example, the Federal Reserve Bank of New York stores and protects gold for a number of central banks and foreign governments. The US Bullion Depository in Fort Knox, Kentucky houses most of the gold bullion belonging to the United States
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However, within the pattern of protracted steady decline in the purchasing power of fiat currencies over the long run, the price of gold can be highly volatile at any one time for a range of obscure reasons. Peaking at $850 per troy ounce on January 21, 1980, gold fell to $285 in February 1985 and recovered to reach $800 in November 1987, all within a period of seven years. Having failed to overtake its historical peak price for the second seven-year period, gold fell back down to $357 in July 1989. It rose to a high of $417 seven years later in February 1996, only to fall back to $250 in July 1999. Gold was $35 cheaper per ounce in 1999 that it was on 1985, 14 years before, and $35 was the price set for an troy ounce of gold at Bretton Woods.

Notwithstanding common perception, the above indicates that gold is not a totally reliable store of value even for the long run. The price of gold had been and still can be detached from general inflation rate in the global economy for extended periods. For example, from its peak of $850 per troy ounce set in January 1980, the gold price was falling towards the end of the same year when economic data and central bank policy would suggest that it should be rising, with US inflation rate reaching 14.5%, bank prime rate at 20.5% as a result of Fed chairman Volcker setting the Fed funds rate at 20% by December 1980, with the unemployment rate at 10.8%, and 30-year fixed rate mortgage at 18.5%.

Gold price unrelated directly to inflation rate

In 2008, the gold price kept rising when economic data would suggest that it should be falling, with the US inflation rate falling from 5.6% abruptly to 1.07% by November, and the bank prime rate fell to 3.5% while the Fed funds rate was lowered to 0-0.25% in December, with unemployment at 10.7% and 30-year fixed rate mortgage at 6%. These figures were clear signs of a severe liquidity trap, which John Maynard Keynes defined as a drastic fall in market confidence giving rise to a liquidity preference that overrides otherwise normal stimulus effects of low interest rates on the economy.

http://www.atimes.com/atimes/Global_Economy/MA08Dj03.html

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