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Explainer: Why Is Price Of Gold Dropping?

Investments in anything, particularly something as spellbinding as gold, are always influenced by hopes and fears that make people run in herds.
Investments in anything, particularly something as spellbinding as gold, are always influenced by hopes and fears that make people run in herds.
After years of gains, the price of gold is steadily dropping. Here are five things to know about the decrease in the value of gold.

How much is the price of gold falling?

Over the past two weeks, the price of gold has dropped around 15 percent. It sank to $1,180 an ounce on June 27 -- its lowest value in nearly three years -- before rising again slightly to $1,229 when markets closed on June 28. That plunge is in such dramatic contrast to gold's record-breaking price of $1,895 an ounce in 2011 that analysts widely say that gold is losing its shine for investors and could continue to weaken.

Why is the value of gold dropping?

People usually invest in gold in two circumstances. One is when they fear inflation rates are eroding their spending power and they want an investment that they believe will hold its value better than cash. Another is when they see banks pay such low interest rates that gold seems to offer a better return on their investment than other options like savings accounts or bonds.

But if such concerns have pushed people to buy gold since the global economic crisis started in 2008, recent events are giving them cause to reconsider.

On June 19, Federal Reserve Chairman Ben Bernanke announced that if the U.S. economy and job market continue to improve, the Federal Reserve could begin "later this year" to reduce its current massive injections of $85 billion a month into the economy. When that happens, the result will be a smaller supply of money in the marketplace and that will bring a drop in inflation and a rise in interest rates.

Chitraj Channa, an economist with the London-based Center for Economics and Business Research, says that the U.S. Federal Reserve's plans make safe havens like gold suddenly seem less needed.

"There will be less demand to hedge against higher levels of inflation. As [the Federal Reserve's monetary stimulus program] is sort of tapered off and interest rates come up, there is going to be less upward pressure on the rate of inflation, which means there will be less demand for gold," Channa explains.

Are there additional reasons why gold is falling?

Yes, and they concern the biggest investors of all -- countries that buy gold.

During the global economic crisis, many countries have sought to increase their gold holdings so they would not be left with too much of their reserves in hard currency that could lose value.

Last year, central banks' gold purchases rose to a 48-year high and represented 12 percent of global demand, according to the World Gold Council.

But as the price of gold drops, buying gold looks like an increasingly unpredictable business. Russia, Turkey, Azerbaijan, and Kazakhstan all boosted their gold holdings in March this year, only to see gold's price slump by $270 an ounce by mid-April.

Now, with the U.S. economy looking set to gain strength, the dollar suddenly appears more attractive again. Central banks can choose whether to buy gold or to return to holding hard currency, and the previous upward pressure they put on gold prices is easing.

How rational, and how irrational, is the flight from gold?

Investments in anything, particularly something as spellbinding as gold, are always influenced by hopes and fears that make people run in herds.

Julian Jessup, head of commodities research at Capital Economics in London, says some of those selling their gold now may have an exaggerated sense of how quickly the economic situation is changing.

"I think those concerns are overdone, the [U.S. Federal Reserve] is going to continue to be buying assets for some time yet and expanding the monetary base and also interest rates are likely to remain very low for the foreseeable future, not only in the United States but in other major developed economies," Jessup says.

"So, I think some of the sell-off [of gold] for that reason alone has been overdone. But there has clearly been a big change in sentiment towards gold on the back of what the Federal Reserve has been saying."

Is there a limit to how much gold will fall?

That is the most difficult question of all. Jessup expects the price to stabilize soon.

"Our gut feeling is that gold probably will find a floor fairly soon. A lot of the factors that have undermined it recently are probably a bit overdone," he says.

"But, equally, we don't expect it to return to anywhere near the highs where it has been over the past few years because that was very much pricing in the prospect of a worst case with a global hyperinflation or the possibility of a complete breakdown of the financial system and I think those fears have passed, too."

Jessup predicts gold's price will firm up again "around current levels or maybe slightly lower."

Other analysts point out that gold was about $800 an ounce before the global economic crisis began in 2008, so there is little reason to expect it to fall beyond that.

But caution about any predictions is in order. As early as the start of this year, analysts were widely predicting gold would continue upward past the $2,000 an ounce mark. Instead, it raced off in the other direction.

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