The retreat has most certainly caused “gold bugs” considerable angst. But they can relax.

This “retreat” is only temporary.

Indeed, gold could easily spike above the $1,500 level this year, says Money Morning Contributing Editor Martin Hutchinson. After all, worldwide monetary policy, global supply-and-demand, and expectations built up from past performances already have combined to ignite the earlier rally that took gold to its record levels just a few short months ago.

Many of those factors remain in place.

And now, three additional catalysts are ready to power gold prices to even greater record levels. Those new catalysts are:

• Inflation.
• Oil prices.
• Fatter wallets in emerging markets.

Inflation and Gold

Global inflation will be a key – if not the key – factor because of gold’s established reputation as an inflation hedge.

Since September, the U.S. Federal Reserve has lowered interest rates seven times – chiefly because of a subprime-mortgage mess that grew into a global financial crisis.

Many foreign central banks have either reduced interest rates in kind, or opted to stand pat, even though inflationary forces in their own markets actually dictated that a rate increase might be a wiser move.

Low worldwide interest rates – arguably an artificial situation, of sorts – has stoked global inflation and caused the greenback to plunge to record lows against other major currencies. And the weak greenback has been a key catalyst behind the escalation of oil prices.

As Money Morning’s Hutchinson has predicted, however, the Fed and other central banks will eventually be forced to start pushing interest rates higher – a stance that even Fed governors are starting to support.

“And during that period, expect speculative demand for gold to intensify and its price to increase steeply,” Hutchinson said. “The longer the period before the Fed is forced to increase interest rates, the higher gold will go.”

“Black Gold” and Gold

There is a very tight correlation between rising oil prices and rising gold prices. While the torrid oil-price advance may moderate at some point – no market goes straight up or down without interruption – the trend in the crude-oil market clearly is toward higher prices, MoneyWeek reported.

And high oil prices tend to support gold prices.

Referring to the “magic relationship” between oil and gold, Moaz Barakat, the managing director of the World Gold Council, said the fluctuations were natural and in accordance with historic price adjustments.

“If you look at the past 100 years, the gold price was always 10 or 12 times that of oil prices,” Barakat told MoneyWeek. “With oil basically around $100 a barrel, gold prices should be at $1,000 or $1,200. That’s the magic relationship between the two.”

[Editor’s Note: Gold investors have made a killing in the past few years, and gold’s meteoric rise is hardly over. Money Morning contributing editor Martin Hutchinson has predicted the precious metal could climb as high as $1,500 in the near future. For additional profit plays on gold - as well as oil, the U.S. dollar, sovereign wealth funds, emerging markets, agriculture, uranium, biotech and much more - check out Money Morning’s just-published global investing guide, The Essential Investors Playbook. It’s Money Morning’s first foray into the investment-book market, but we’re certain you’ll find it worthwhile.]

Asian Wealth

Naturally, as per capita wealth increases in such emerging markets as China, India and Latin America, demand for “American” goods will soar. That holds true both for American “brands,” as well as for so-called “lifestyle goods” – products that foreign consumers identify as being part and parcel of the “American” way of life. Jewelry, gold, gems, other precious metals all will benefit from the growing ability of the newly forming middle classes to spend on wares that aren’t just necessities.

That’s different from past bull markets for gold, which were solely inflation-driven; that is, investors who were seeking to hedge their bets against rising prices caused gold prices to skyrocket.

To be sure, inflation has been a big factor this time around. Gold prices usually move in the opposite direction of the U.S. dollar. With the dollar weak, and interest rates low, an up-tick in inflation could send gold prices higher.

But for gold prices to really zoom, consumer demand will have to act as an adjunct to inflation. And rising demand from increasingly wealthy consumers in China and India may be just the ticket.

Now that the Internet and satellite TV have allowed these aspiring consumers to see what kinds of wares U.S. consumers regularly have, this new group of Asian consumers also want their own houses, cars, appliances, cell phones, computers and jewelry. They are willing to work to get it. And they are all-too-happy to pay the rising asking price.

The upshot: The wealthier this new group of consumers becomes, the more they’ll envy these goods – and the higher the price tags on those products will climb.

This new source of demand could potentially blunt gold’s run toward $1,500. Naturally, demand drives up prices. And, recently, steep prices are to blame for the 11% decline in gold sales during the Hindu holiday of Akshaya Tritiya, where long-term investments such as gold, silver and real estate are religiously merited as purveyors of prosperity.

Like Christmas, Hindus are constantly reminded of Akshaya Tritiya by a bevy of special sales and advertisements from jewelers and real estate companies. 

This is important to note because Hindus were curbing the religious tradition of buying gold, which sheds light on “how much is too much?”

They’ve watched as oil prices continued to set new records, understanding that global turmoil and rising demand from China means that “black gold” won’t be getting cheaper anytime soon.

They’ve stared as global food prices continued to soar, touching off riots overseas and bringing U.S. lawmakers to the brink of fisticuffs because of debates over whether corn now earmarked for ethanol should be used to fill empty gas tanks, or empty stomachs.

And they’ve waited expectantly as the good old U.S. greenback – whose historic swoon against key global currencies has been exacerbated by an epic rate-cutting campaign by the U.S. Federal Reserve – suddenly reversed course and mounted a two-week rally (despite last Wednesday’s rate reduction, the central bank’s seventh since September).

When they occur separately, each of these developments – increasing oil prices, soaring food and commodity prices, and a plummeting greenback – are highly inflationary. But when they happen in tandem, the ascent in prices can be almost vertical. In such an environment, investors scramble to find a so-called “safe haven” for their money. And the best safe haven has generally been gold.

Until now, that is.

Gold dropped below $850 an ounce last week – representing a decline of more than $182 an ounce, or nearly 17%, from the yellow metal’s March 17 record of $1,032.

The main culprit: The resurgent U.S. dollar. Since mid-to-late April, the U.S. greenback has gained ground against several major currencies, such as the European euro, the Japanese yen, the British pound, the Swiss franc and the Canadian dollar. And that rally could continue, especially now that the U.S. Federal Reserve has all-but-promised to end the ambitious rate-cutting campaign that it’s been operating since mid-September.

But Money Morning contributing editor Martin Hutchinson thinks other forces are at play, too.

“Credit conditions have eased since March because of the Bear Stearns (BSC) bailout and so investors’ fear level is less. [The] stock market is up too, which suggests the same,” Hutchinson said.

Moreover, gold’s meteoric rise from $654 to $1,032 an ounce in a year (a 57.8% gain) attracted a lot of bulls and speculators whose demand helped push prices further skyward. When gold started to slip, gold bulls sold off their holdings, nudging the yellow metal into its current tailspin.

Such a slippery slope is unusual for gold, but those very conditions could be strong drivers of gold’s next rally.

“The gold market is quite illiquid, which is why I think a real speculator panic about inflation could send it zooming,” Hutchinson said.

And inflation could be the catalyst for such a speculative panic.

Inflation, Interest Rates and Gold

Gold may be down from its high, but it’s not out.

“It still looks heavy at this point. The downtrend that we are seeing at the moment is probably going to start slowing down soon,” Taso Anastasiou, technical strategist at UBS Investment Bank (UBS), told Reuters.

In fact, gold’s current price could be seen as a “discounted” entry considering three catalysts – worldwide monetary policy, global supply-and-demand, and past performance – have already ignited a powerful rally that’s virtually certain to carry gold past $1,500 this year.

And, as Money Morning has chronicled, some experts have even predicted that gold prices would reach the $2,000-an-ounce level within the next year or so.

Global inflation will be a key -if not the key – factor. Interest rates have been significantly reduced around the world, with many countries following the Fed’s lead.

To fight inflation, central banks will have to raise rates. But central bankers – including the U.S. Fed – won’t make those moves without a great deal of thought beforehand, Hutchinson said.

“And during that period, expect speculative demand for gold to intensify and its price to increase steeply. The longer the period before the Fed is forced to increase interest rates, the higher gold will go,” he said.

How to Play and Profit from $1,500 Gold

Until the Fed reverses its monetary policy strategy and increases interest rates, gold is one of the best investment bets available in an uncertain economic climate.

Money Morning suggests six gold plays to consider while gold is priced down:

• The simplest way to play gold is through the StreetTracks Gold ETF (GLD), which tracks the gold price directly. And with a $17 billion-plus market cap, it has ample liquidity.

• Barrick Gold Corp. (ABX) is a Toronto-based company with mostly North American production, as well as properties in South America and Africa, and some copper and zinc add-ons. It has a $38 billion market capitalization, so there’s plenty of liquidity. It has a trailing Price/Earnings ratio of 29.65, but a forward P/E of 13.69. By gold-mining standards, this company has a substantial presence, is reasonably valued, and has little political risk. The company also recently sent some very bullish signals to the market and recently reasserted its confidence in meeting its 2008 output target of up to 8.1 million ounces of gold. [For more details, read a related story about Barrick Gold]. Barrick is scheduled to report its first-quarter earnings results tomorrow (Tuesday).

• Yamana Gold Inc. (AUY) is another U.S.-listed Canada-based company, but this one does its mining in Brazil, Argentina, Chile, Honduras and Nicaragua. It has a market cap of $9.7 billion and a trailing P/E of 40, but its forward P/E is only 14. Despite its geographic reach, it faces only a medium geopolitical risk. Expect the company to double production to 2.2 million ounces per year by 2012, primarily in Brazil and Argentina. 

• Gold Fields Ltd. (GFI) is a South African company that mines in South Africa, Ghana, Australia and Venezuela (where it just sold control to a local company, reducing its exposure to an arguably risky market). The company’s market cap is $9 billion, its trailing P/E is 20.98, and its forward P/E is 10.41. It faces a somewhat upper-medium political risk, depending on what you think of South Africa, where the electricity supply to the gold mines is currently unreliable and there’s a good chance of Jacob Zuma winning the presidency in April 2009. Given his record as an anti-Western leftist, and the corruption charges he faces, his potential return can only be viewed as a major negative.

• Kinross Gold Corp. (KGC), another U.S.-listed Canadian company, engages in gold and silver mining, with primary operations in Canada, the United States, Brazil, Chile and Russia. In February, Kinross issued shares to buy a large Brazilian/Russian company. Political risk is low-medium. It has a market cap of $14 billion, a trailing P/E of 32.32, and a forward P/E of 16.03. It looks somewhat expensive. 

• Royal Gold Inc. (RGLD) is a U.S.-based company with mines in Nevada, Mexico and Argentina. It faces low political risk. But with a market cap of $905 million, a trailing P/E of 40.56, and a forward P/E of 22.38, the stock looks expensive.

Since then, gold soared to more than $1,000 an ounce, creating quite a nice return for investors who acted on our prediction. Since achieving that peak, gold prices have declined a bit. In fact, just last week, gold prices dropped below the $900 mark, prompting gold bears to say that the great gold bull market has reversed itself.

Let me say right now: They’re wrong.

In fact, now I’m saying that – thanks to three key catalysts – we may well see gold at $1,500 an ounce this year, if not higher.

Those three catalysts – worldwide monetary policy, global supply-and-demand for gold, and gold’s past performance – have already ignited a powerful rally that’s virtually certain to carry gold to much higher price points, despite the breather the rally appears to be taking right now.

Don’t be fooled. Understand the forces at work here. Then watch as gold prices soar.

Three Reasons Gold Prices Could Vault

Every rally needs a catalyst – something that ignites and then fuels the bullish trend. As noted above, gold has three. Let’s take a look at each of them:

1. Monetary policy: More than for any other investment, gold’s price depends primarily on the world’s monetary policy. When monetary policy is loose, as it was in the 1970s, gold prices soar. When it is tight, as in the 1980s, prices decline sharply. When gold prices advanced sharply after 2000 that should have told the U.S. Federal Reserve and others that monetary policy had once again become too loose.

Indeed, it became too loose after 1995, but gold prices were temporarily suppressed by the world’s central banks (the British Treasury, then headed by Gordon Brown, sold the nation’s entire gold stock in 1999, at a price of around $280 per ounce – yet another reason for British taxpayers to be annoyed with their current Prime Minister).

The rise in gold prices is thus easily explained. U.S. monetary policy has been loose since 1995, and particularly since the recession of 2001 and 2002, and other countries have followed the United States’ lead. According to International Monetary Fund (IMF) statistics, the world’s total foreign exchange holdings increased from $1.4 trillion in 1997 to $6.4 trillion last year, an average annual increase of 16.4% – compared with a 7% annual increase in Gross World Product. With that kind of monetary expansion, it is not surprising that gold prices have risen; the metal is universally regarded by both the sophisticated and unsophisticated alike as the premier hedge against inflation.

Since the subprime crisis exploded onto the scene last September, the Fed has been lowering interest rates. And the Fed, the European Central Bank (ECB) and the Bank of England have been providing additional lending facilities to banks and investment banks. The lowering of interest rates has been quite dramatic, from a Federal Funds rate of 5.25% before September to 2.25% now. Even 10-year Treasury bonds, currently yielding 3.6% or so, are providing investors with a yield that remains well below the rate of inflation (currently somewhere above 4% and trending higher). The bailout of The Bear Stearns Cos. Inc. (BSC) and the continuing efforts of the ECB to restore liquidity to the short-term euro deposit market are having the same inflationary effect. As a result, commodity prices have soared in the last six months, as has the price of gold.

Gold has sold off in the past couple of weeks as the market has focused on the U.S. recession, believing that inflation pressures will decline, but that’s wrong. Monetary expansion continues and even is intensifying, meaning that inflationary pressures will increase and gold will be the beneficiary.

2. Global Supply and Demand: For most commodities, price rises have an effect on supply and demand; a higher price increases supply and reduces demand, in “price elasticity.” With oil, for example, a 10% rise in price reduces demand by about 1% to 1.5%, meaning that oil has a price elasticity of 0.1 to 0.15. That’s what conventional economics tells us, and it’s a good thing, too. Without the effect that rising prices have on supply and demand, a shock in the market could produce instability, with prices zooming off to infinity.

Gold appears to be an exception. For gold, rising prices appear to increase demand and decrease supply. According to the World Gold Council, world gold demand in 2007 increased by 4% in volume terms to 3,547 metric tons, or about 20% in dollar terms; the average dollar price of gold increased 16%. Gold supply decreased 3% to 3,469 metric tons. Of that, mine supply decreased 3% to 2,047 metric tons, while official sector sales increased 32% to 485 metric tons and gold scrap recycling decreased 15% to 937 metric tons.

This suggests a gold supply/demand price elasticity of minus 0.4; that is, if prices increased 20%, demand would increase 5% and supply would drop 3% to 4%.

That simply cannot be true in the long run – otherwise, the gold market would explode, swallowing the world economy. Nevertheless, while real global interest rates remain low, gold should retain its current dynamics, with speculative demand increasing as prices rise. Since the pools available for speculative investment are much larger today than they were in 1980, the predicted gold price “spike” could even move well beyond 1980’s peak price of $2,250 an ounce (as measured in today’s dollars).

3. Comparison with past peaks: If gold had increased in price since 1997 by the same percentage as world dollar reserves, it would currently be trading at around $1,280 per ounce. And the current speculative appeal of gold, compared to its inactivity 10 years ago, suggests it could go higher than this. The 1980 gold price peak of $875 per ounce intraday is equivalent to more than $2,200 per ounce when inflation is taken into account.

That occurred in a period when equity investments had fallen deeply out of favor [remember the famous August 1979 "Death of Equities" BusinessWeek cover story?], when bonds had performed miserably for more than 30 years and when oil was not yet significantly publicly traded. Thus, when inflation rose to a frightening level above 10%, the world’s entire investment pool flooded into gold – and, to a lesser extent, silver.

Today, while the Fed and other central banks keep interest rates below the level of inflation (roughly 2.5% with an inflation rate of about 4.0%), gold prices are likely to continue increasing at a rapid clip, though they may retreat temporarily for a few weeks at a time. Nevertheless, while the global investment pool is many times larger today than in 1980, it has recent memories of making good profits in stocks, so a money-fueled bubble would be unlikely to flow entirely into gold as it did in 1979 and 1980. However, if gold is unlikely to reach $2,200 in the short term, its greater attraction to investors today compared with 1997 suggests that it will rise well above $1,280.

How high can gold go?

Just let me show you…

Price Projections for the Yellow Metal

At some point, with monetary policy as loose as it is currently, inflation will probably accelerate to a point that will force the world’s central bank policymakers to take action. When that happens, interest rates will have to be sharply increased. Then – and only then – will the risk-reward potential for gold change enough that wise investors should sell.

That final peak might come immediately before this sharp uptick in interest rates. Or it might lag by a few months, as it did in 1980 [Fed Chairman Paul Volcker’s first big interest rate rise was in October 1979; gold finally peaked in January 1980]. Remember that recessions don’t stop gold prices from rising. Gold’s first major peak was in the middle of the 1974 recession and its second was well into the first part of the 1980 recession.

As inflation accelerates, it will probably take a few months for clear inflationary signals to cause the Fed to reverse its policies and attack inflation. And during that period, expect speculative demand for gold to intensify and its price to increase steeply. The longer the period before the Fed is forced to increase interest rates, the higher gold will go.

For example, if rates aren’t increased before the end of 2009, gold could easily soar well through $2,000 – a price point we said was possible back in July, when gold was trading at $650 an ounce.

Even if $2,000 seems to be a somewhat aggressive price target for gold (because rising inflation is likely to cause the Fed to reverse policy before it gets there), understand that a target price of $1,500 certainly is not. And it seems very probable that with speculative demand tending to increase, gold could reach that latter level before the end of 2008.

The bottom line: Until the Fed reverses monetary policy and increases interest rates, gold is one of the best investment bets in an uncertain world.

Six Gold Plays to Consider… Now

• The simplest way to play gold is through the StreetTracks Gold ETF (GLD), which with $19.8 billion outstanding has ample liquidity, and tracks the gold price directly. Alternatively, you should consider buying gold mining shares. Here are five possibilities:

• Barrick Gold Corp. (ABX) is a Toronto-based company with mostly North American production, as well as some South America and Africa properties, and some copper and zinc add-ons. It has a $38 billion market capitalization, so there’s plenty of liquidity. It has a trailing Price/Earnings ratio (on the most recent 12 months) of 34, but a forward P/E (on the next 12 months) of 16. By gold-mining standards, this company has a substantial presence, is reasonably valued and has little political risk. And, as Money Morning reported, the company also recently sent some very bullish signals to the market and then this week said it was confident that it could meet its 2008 output target of up to 8.1 million ounces of gold [For more details, read a related story about Barrick Gold in today’s issue].

• Yamana Gold Inc. (AUY) is another U.S.-listed Canada-based company, but this one does its mining in Brazil, Argentina, Chile, Honduras and Nicaragua. It has a market cap of $9.7 billion and a trailing P/E of 40, but its forward P/E is only 14. Despite its geographic reach, it faces only a medium geopolitical risk. Expect the company to double production to 2.2 million ounces per year by 2012, primarily in Brazil and Argentina. 

• Gold Fields Ltd. (GFI) is a South African company that mines in South Africa, Ghana, Australia and Venezuela (where it just sold control to a local company, reducing its exposure to an arguably risky market). The company’s market cap is $9 billion, its trailing P/E is 24, and its forward P/E is 11. It faces a somewhat upper-medium political risk, depending on what you think of South Africa, where the electricity supply to the gold mines is currently unreliable and where there’s a good chance of Jacob Zuma winning the presidency in April 2009. Given his record as an anti-Western leftist, and the corruption charges he faces, his potential return can only be viewed as a major negative.

• Kinross Gold Corp. (KGC), another U.S.-listed Canadian company, engages in gold and silver mining, with primary operations in Canada, the United States, Brazil, Chile and Russia. In February, Kinross issued shares to buy a large Brazilian/Russian company. Political risk is low-medium. It has a market cap of $14 billion, a trailing P/E of 39, and a forward P/E of 19. It looks somewhat expensive. 

• Royal Gold Inc. (RGLD) is a U.S.-based company with mines in Nevada, Mexico and Argentina. It faces low political risk. But with a market cap of $905 million, a trailing P/E of 44, and a forward P/E of 25, the stock looks expensive.