Gold retains allure as central banks battle deflation

By Frank Tang

NEW YORK (Reuters) - Even as fears of deflation prompted the U.S. Federal Reserve on Tuesday to slash interest rates to the bone, gold retained its allure as an inflation hedge among investors watching central banks flood financial markets with money.

The conventional wisdom is that the price of bullion, seen as a safe haven that retains value in times of inflation, will drop on the threat of deflation, a devastating economic state in which overall prices decline.

But fund managers said they expect gold to stay well bid as central banks expand money supply to bolster the economy at the expense of fighting inflation.

"Gold does not benefit from deflation, but rather it benefits from the cure of the deflation," said Axel Merk, manager of the Merk Hard and Asian Currency Funds, with $300 million (194 million pounds) of assets.

With U.S. rates and Treasury yields at rock bottom, Merk said, the dollar will weaken.

The Fed cut its target for overnight interest rates to a record low zero to 0.25 percent. The central bank said it would employ "all available tools" to dispel a year-long recession.

Brian Hicks, co-manager of the $500 million Global Resources Fund at U.S. Global Investors, said he expected gold to revisit $1,000 some time next year, driven by negative real interest rates and the massive amount of money to be injected into the system by central banks.

"At some point, the market is going to transition from an environment of concerns over deflation to an environment of concerns over inflation, and that's the real inflection point for gold," said Hicks.