…The traditional motive behind investing in gold is as a hedge against inflation but the hedge properties of gold are increasingly questioned. In fact, its role as an inflation hedge is perhaps the most debated and ambiguous issue in the financial press and academic literature. [This article analyzes all the research and puts forth a convincing conclusion.]
The above comments, and those below, have been edited by Lorimer Wilson, editor of munKNEE.com (Your Key to Making Money!) and the FREE Market Intelligence Report newsletter (see sample here – register here) for the sake of clarity ([ ]) and brevity (…) to provide a fast and easy read. The contents of this post have been excerpted from an article* by Arkadiusz Sieron/Przemyslaw Radomski CFA (sunshineprofits.com) originally entitled Is Gold an Inflation Hedge? and which can be read in its unabridged format HERE. (This paragraph must be included in any article re-posting to avoid copyright infringement.)
- Some economists believe that gold
- Others claim the opposite
- To make things worse, the effectiveness of gold as an inflation hedge depends on the country.
However, once one digs deeper into the literature, a consensus in encountered:
- The effectiveness of gold as an inflation hedge depends on the time horizon
- The yellow metal serves as an inflation hedge in the long-run
- but not in the short-run
Let’s look into data which confirm that gold preserves its value over a long time.
- In the period from 1895 to 1999, the real price of gold increased, on average, by 0.3% per year, which means virtually no change in the real value of gold over a one-hundred year period…
- In the “medium-term” period of 1980 to 2001 the nominal price of gold decreased by almost 70% and, adjusting for inflation…fell by 81.6%.
- As you can see on the chart below, the real price of gold calculated as the ratio of nominal price of gold relative to the CPI index has been declining from 1980 up to 2001.
Chart 1: Gold price adjusted for inflation (calculated as the ratio of nominal London morning fixing price of gold relative to the CPI index) from 1968 to 2015
Why is gold an inflation hedge in the long-run, but not in the short-run?
Well, one might say that over the very long run, all prices should eventually rise in line with the overall pace of inflation; however this is not strictly true, because money is not neutral, even in the long term. The explanation lies in the history of gold, which was used as money, or at least as the base reserve currency, for thousands of years until 1971. It implies two things:
- When different governments temporarily suspended the gold standard (or just implemented legal tenders laws), and started printing paper currencies, the yellow metal was still used as money, especially in the international markets.
- Thanks to this monetary demand combined with a stable supply (gold cannot be printed), gold has always preserved its purchasing power. In other words, when governments introduced fiat money, gold was the parallel currency. Therefore, when governments printed huge quantities of continentals or greenbacks, their exchange rate against gold had to decrease, or the value of gold had to rise (when the fiat currency is massively printed, the opportunity costs of using gold as a store of value and exchange medium decrease).
- The U.S. dollar was fixed to gold until 1971, and given its mass printing it was fixed at a significantly overvalued exchange rate of $35 per ounce.
- When President Nixon ended dollar convertibility to gold, the purchasing power of gold substantially increased in an understandable reaction to the prolonged period when the dollar had been inflated and gold had been held at a fixed price.
- The price of gold was additionally supported by fears over the new monetary system based on freely fluctuating fiat currencies.
The exchange rates are much less volatile and unpredictable than in the early 70s and, as such, the yellow metal is purchased only when people fear that the current monetary system will collapse or the paper currencies will return to their intrinsic value, which is practically zero. This is why, according to Klement (2015),
- the most reliable relationship exists between gold and strong increases in inflation,
- while moderate increases in inflation or declining inflation do not materially impact the price of gold in either direction.
As you can see in chart 2 below, the gold prices were increasing in the 70s, when the inflation rate was high and accelerating, while they were decreasing in the 80s and the 90s, when the inflation rate was declining.
Chart 2: Gold prices (yellow line, left scale) and inflation rates (red line and right scale) from 1968 to 2015
Summing up, given the opportunity costs…gold serves as an inflation hedge only when there is relatively high inflation, usually accompanied by fear about the current state of the U.S. dollar and the global monetary system…i.e. only if it fits in its role as safe-haven.
Related Articles from the munKNEE Vault:
To answer the question “what drives the prices of gold” we have to determine the nature of gold. Is it a commodity, a currency, neither or both? This article does just that. Read on.
Many in the investment community swear by the old myths about gold, but is there any truth in them? If investors examined the facts, they would find that the most commonly held anti-gold beliefs do not hold water and, once the general public realizes that these beliefs are not valid, the price of gold will be much higher.