Is the 10-year gold rally finally ending?

FILE - In this undated handout file photo from Newmont Mining Corporation, gold nuggets and bars are shown. In December 2007, gold for about $840 an ounce. A little over a year later, it rose above $1,000 for the first time. It climbed gradually for the next two years. Then in March 2011, it began rocketing up. On Tuesday, Aug. 16, 2011, it traded at $1,788 an ounce, up 26 percent this year. (AP Photo/Newmont Mining, File ) AP Photo/Newmont Mining, File

(MoneyWatch) The 21st Century has been tough on stocks and real estate, but it's off to a pretty good start for gold. An ounce of the metal sold for around $300 in 2000, and rose to a peak of $1,920.30 in September 2011. Since then the price has fallen to around $1,600, a 17 percent decline. Prices are down about 7 percent this year, though in recent months the price has stabilized around $1,600.

Will gold prices continue to stagnate or fall even farther?

To answer this question, it's useful to look at the reasons for the run up. The increase in the price of gold has been driven primarily by two things: A large increase in the demand for gold in India and China, and the use of gold as a hedge against inflation, particularly since the onset of the financial crisis.

Similarly, the price decline since September 2011 can be attributed to a weakening demand for gold from China and India -- these two countries have accounted for just under half of global demand for gold in recent years -- and less worry about an outbreak of inflation due to the policies of the Federal Reserve and other central banks.

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The weakening demand in China and India is due to the recent decline in economic activity in developing countries along with changes in currency values, particularly for India. There is widespread worry that "the great slowdown" in the developing world will be long-lived -- this is not just a temporary problem. If that is true, the demand for gold is likely to remain depressed for quite some time. Of course, it's not certain that the slowdown will be permanent, but it would be wise to allow for this possibility.

The other factor that will determine where the price of gold is headed is the demand for gold as an inflation hedge. When the financial crisis hit and the Federal Reserve expanded its balance sheet dramatically to ease credit market conditions, many people predicted that an outbreak of inflation was just around the corner. This drove investors to purchase gold as an inflation hedge, pushing the price higher. But the inflation did not materialize, and demand for gold as an inflation hedge has waned.

But this could change. How the demand for gold to hedge against inflation evolves over time will depend a great deal on movements in the actual inflation rate as well as Federal Reserve policy announcements and the situation in Europe. If there is a sudden uptick in inflation, the announcement of another round of easing by the Fed, or indications that the ECB will ease its policy stance in response to the regions debt problems, then many investors will flee into gold. But for now the fear of inflation does not appear to be on the rise -- as the Federal Reserve noted after its last monetary policy meeting at the beginning of this month, "longer-term inflation expectations have remained stable." Europe, however, is more uncertain.

In the long-run I have confidence that the Fed and the ECB will keep inflation under control, so the use of gold as an inflation hedge is likely to fall to its historical norm. There could be short-run jitters in the inflation rate, and probably will be, but the hawkish views on inflation at both the Fed and the ECB make the long-run outcome relatively certain. The wildcard is what happens to output growth in developing economies. These countries are likely to continue to experience slow growth in the near term, so the decline in demand is not over (so long as inflation expectations remain stable), but I don't think the growth slowdown in developing countries is permanent and in the longer run relatively strong demand growth will return.

Keeping in mind that if I could predict gold prices perfectly, I'd have made my fortune and retired long ago, in the short-run I don't see anything that will reverse the current trend for gold prices. They are likely to fluctuate around their current value of $1,600, or perhaps fall a bit further -- it depends upon what happens to economic growth rates in China and India over the next few years. In the longer run there are considerable uncertainties, but I expect robust growth to return to developing countries, though not right away, and this should cause the upward pressure on gold prices, and commodity prices more generally, to return.

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