Has Gold Appreciated Too Much to Be Inflation Protection?

It’s been no secret that gold prices have been creeping up lately. At just over $900 per troy ounce, gold has run up over $90 in the past 16 days. And while we haven’t reached last year’s record price of $1002.80, moving over $900 is significant.

To put things in perspective, gold has only moved above $900 for a few brief periods historically – gold prices we’ve only seen in early 2008. If you’re looking at ways to invest at these prices, the SPDR Gold Trust ETF (NYSE: GLD) is an easy way to do it.

Option buying has been very bullish – traders still think the price has higher to go. And they may have something there. Gold does well in inflationary environments.

It’s no secret that the Fed has been flooding the markets with cash. And eventually all of that cash is going to cause inflation to creep up. The question is whether the price of gold has appreciated too much to be the inflation protection it needs to be?

Inflation has been ticking in at the lowest levels since 1954. Other than the influx of capital, there isn’t another major inflationary pressure out there. Food and fuel don’t seem to have it in them, and decreasing wages from an increasingly unemployed populace will continue to drive down prices.

Or, it could be that all of this inflation-speak is nothing more than a smokescreen for the fact that the United States and China haven’t been playing nicely. And the rush to gold has been in response to the world’s two largest economies slap-fighting over Yuan rates.

Comments

[Chris B:]

A lot of people misunderstand the link between gold prices and inflation. If you overlay a chart of gold prices with a chart of the CPI, you will see that gold is poorly correlated with inflation. If you believe that CPI dramatically underestimates increases in the actual cost of living, gold's performance vs. true inflation is that much worse.

Gold's price from the mid-80's through 2000 were basically flat. It did not increase 3% per year with the CPI and they certainly did not increase at the higher rates of inflation predicted by alternative methods. If gold tracked inflation, it would increase each year with either the CPI or your method of choice. However it obviously did not. Since 2000, gold's price has tripled. But are prices today 3X what they were in 2000? They're higher, yes, but not 3X higher. In the short term, 2008 inflation was running about 5% in the first half of the year, and negative %5 in the second half. Yet gold's price barely reacted.

A lot of conspiracy theories have emerged to explain why inflation does not predict gold prices, but it may make more sense to consider an alternative explanation rather than inventing international Dr. Evil type conspiracies. It's very simple:

Gold prices track inflation EXPECTATIONS, not inflation itself. By inflation expectations, I mean what today's investors think inflation will be 2-3 years out.

When gold investors expect 3% inflation, as they did from the mid 80's until 2000, gold sells in the $300 range.

When gold investors expect 9-10% inflation, as they did in the early 80's and as they do today, gold's price can range from $900-1000.

Gold's price equals $100 times the expected future inflation rate as a whole number. Price = $100 * (expected inflation in 2-3 years).

Because actual inflation often differs from expectations, gold's price is uncorrelated with inflation. Gold investors make money in an environment of rising expectations for inflation and lose money when those expecations fall. This explanation predicts real-world gold prices a lot better than anything else I've heard on this site. If you have a better model, let's hear it.

Jan 27 11:15 AM

[Hefaistos:]

The headline to this article is somewhat funny. Supposedly, if gold was an inflation protection, why does it then rise in times of deflation? Ah, because it will rise even more in times of inflation.
I think it's relevant to put the price of gold in relation to the Yen rate. Gold has another 10% or so upward potential in terms of the very strong yen. And japanese are big buyers of paper gold.

Jan 27 11:17 AM

[lance sjogren:]

Your theory is interesting. The two issues I would take with it are:

1). The fixed $100 in your formula implies that inflation correlates to a FIXED dollar, rather than an inflated dollar, over time. When a devalued dollar results in prices in general going up, I can't believe that gold is a unique commodity that is not subject to such price inflation. Yes I can believe monetary inflation and gold inflation are not directly syncrhonized, but over long spans of time, gold has got to go up to some degree as the dollar goes down. After all, decades ago gold was in the $20-40 range. By your theory that means that back then people anticipated 0.2-0.4 inflation. I can't buy that.

But that is just looking over very long spans of time. I can believe that over shorter spans, even a decade or two, you probably are indeed right there is no one to one correlation between the dollar and gold.

Your point about gold anticipating inflation also makes sense in that we know the stock market is based on not on today's economy but on the anticipated economy at some point down the road. it seems logical that gold would act in a similar manner.

The other point I would raise is: To test your theory, are there any reliable gauges of anticipated inflation? If there aren't, then it would appear that there is no way to test your theory, unless one were to postulate that gold tracks with the ACTUAL inflation that occurs 2-3 years down the road rather than anticipated. But that would seem to violate the law of cause and effect, because investors today do not know what the actual inflation rate will be tomorrow.

Anyway, an interesting theory.

Jan 27 11:35 AM

[yellowhoard:]

Well stated Smarty!

Now could you help me out?

Like most readers of this page, I own gold. I know it's going up. My question is "how will I know that the long wave up is over and it's time to switch to more profitable areas of investment?"

Thanks!

Jan 27 12:25 PM

[GMiki1:]

<<Or, it could be that all of this inflation-speak is nothing more than a smokescreen for the fact that the United States and China haven’t been playing nicely. And the rush to gold has been in response to the world’s two largest economies slap-fighting over Yuan rates.>>

Oh, I see. Nothing else has been going on in the world. We didn't overleverage debt using junk paper rated triple A and infect the globe with these toxic "assets." It's all about a currency rate war between the U.S. and China.

Well, in that case, I'll dump my gold and go buy Citibank stock. Thanks for clarifying things.

Jan 27 12:47 PM

[Chris B:]

Hi lance,

1) Regarding the fixed $100 in the formula. This is a good criticism - that base $100 would in theory lose value to inflation. Perhaps, as Smarty_Pants suggests, we should consider both the USD and gold to be currencies and think of gold's "price" as an exchange rate between currencies, rather than a price for a good. If they both fit the definition of currencies, then they theoretically both can experience inflation, just as both the euro and the USD can both experience inflation. I know this contradicts gold dogma, but anything that is used as a currency has a fluctuating supply and purchasing power, even gold. I'm OK with this gold heresy - after all, my goal is to explain the data, not defend popularly held ideas. If gold and the USD experienced similar inflation over the last 3 decades or so, the $100 peg for the exchange rate could stay close to accurate.

2) The model does a good job of explaining gold-dollar exchange rates for about the last 30 years, but fails for earlier periods. I would argue that this is because various forms of a gold standard acted as a currency peg and prevented free-market floating exchange rates like we have now. The model can only be applied to time periods in which there is an open, floating market for gold without a gold standard.

3) "To test your theory, are there any reliable gauges of anticipated inflation? If there aren't, then it would appear that there is no way to test your theory..."

Excellent point. I'm still looking for such a gauge, as the critical inflation expectations datapoint is still anecdotal in nature. Old surveys are one possibility and the spread between treasuries and TIPS is another (although TIPS only go back to '98). However the fundamental problem is that we need to measure inflation expectations AMONG GOLD INVESTORS OR POTENTIAL GOLD INVESTORS, not the wider market, which mostly ignores gold. The people buying treasuries for yields that predict 2% inflation for 20 years right now are not the same people buying gold for $900/oz. The people buying TIPs mostly trust the CPI. Gold investors seem to trust their gut. And who knows who the people answering surveys are - your average Joe on the street will just quote to you what he heard in the media and probably isn't betting money on his prediction. I am unaware of any survey of gold investor estimates of future inflation, and even if one existed, it would be hard to be sure if everybody was talking about the same thing, as there is disagreement among gold investors about how inflation should be calculated. Some gold investors even say that inflation is defined as a rise in the price of gold!

4) "30 years from now would you rather have 10 oz of gold or $9,000?"

I assume you mean $9k today vs. 10 oz gold in 30 years.

I would need to have a good reason before I could answer that question, which is the point of figuring out how gold's exchange rate works. The old theory, that gold just goes up as inflation goes up, obviously doesn't work. If it did, people who bought gold in 1982 would have seen their investment increase by about 3% a year (or more, if you distrust govt. stats). Instead the value of their investment plummetted and stagnated for decades. For those who bought at $700 in the early 80's and held for 28 years, their annualized before-inflation ROI is finally positive - at 1% before commissions - which means they still lost at least 2% a year in purchasing power (more if you distrust the CPI, and even more if they paid insurance and storage expenses). In the meantime, their opportunity costs for that money were staggering. Bank CD's in an IRA at an average yield of 5% could have turned that $700 into $2,613 by now instead of the $900 that the ounce of gold would bring. Of course, past performance is no guarantee of future results. But this example illustrates why we need a solid, back-tested explanation for why we expect our investments to appreciate. "Gold just rises with inflation" doesn't cut it.



On Jan 27 11:35 AM lance sjogren wrote:

>
> Your theory is interesting. The two issues I would take with it are:
>
>
> 1). The fixed $100 in your formula implies that inflation correlates
> to a FIXED dollar, rather than an inflated dollar, over time. When
> a devalued dollar results in prices in general going up, I can't
> believe that gold is a unique commodity that is not subject to such
> price inflation. Yes I can believe monetary inflation and gold inflation
> are not directly syncrhonized, but over long spans of time, gold
> has got to go up to some degree as the dollar goes down. After all,
> decades ago gold was in the $20-40 range. By your theory that means
> that back then people anticipated 0.2-0.4 inflation. I can't buy
> that.
>
> But that is just looking over very long spans of time. I can believe
> that over shorter spans, even a decade or two, you probably are indeed
> right there is no one to one correlation between the dollar and gold.
>
>
> Your point about gold anticipating inflation also makes sense in
> that we know the stock market is based on not on today's economy
> but on the anticipated economy at some point down the road. it seems
> logical that gold would act in a similar manner.
>
> The other point I would raise is: To test your theory, are there
> any reliable gauges of anticipated inflation? If there aren't, then
> it would appear that there is no way to test your theory, unless
> one were to postulate that gold tracks with the ACTUAL inflation
> that occurs 2-3 years down the road rather than anticipated. But
> that would seem to violate the law of cause and effect, because investors
> today do not know what the actual inflation rate will be tomorrow.
>
>
> Anyway, an interesting theory.

Jan 27 01:01 PM

[The Vet:]

Smarty has it right... By continually measuring gold in US dollars (or any other fiat currency) we are comparing one variable against another variable. We shouldn't be saying "gold is up today" we should be saying that the "US dollar is down today".

If the values of all currencies were reported in the press and on the web as the number of currency units, be they dollars, yen, pounds or euros that could be bought with one once of fine gold then we would have a fixed measure to make real comparisons. My using the same measure for all commodities as well we could determine real prices against a real standard. No fiat currency is a real measuring standard today as they are all being manipulated by traders, banks and governments to meet their agendas.


On Jan 27 11:40 AM Smarty_Pants wrote:

> I would suggest recasting the question somewhat. Your frame of reference
> is limited.
>
> Instead of citing the "price of gold" utilize the "value of dollars".
>
>
> Anyone who buys an ounce of gold will always have an ounce of gold.
> The question is, how many dollars can you trade it for? What is the
> value of the dollar going to be in the future?
>
> Given that the supply of tradable gold is increasing very slowly
> and the supply of dollars (or digital equivalents) is increasing
> very quickly, I don't see how the number of dollars per ounce of
> gold will decrease over the long run.
>
> I recall reading somewhere that the only real power a central bank
> possesses is the power to devalue the currency.
>
> Gold has been a much better store of value than the dollar ever will
> be for the long term.
>
> I posted this information some time ago for another similar article
> on SA, the 2008 data may be a bit dated now, but the point holds.
> Note that 1971 is when Nixon closed the gold convertability window
> and any pretense of monetary restraint was abandoned:
>
>
> Median house price in 1970: $17,000 (US Census)
> Price of gold in 1970: $38/oz
> One median 1970 house: 447+ oz of gold
>
> Median house price in 2000: $119,600 (US Census)
> Price of gold in 2000: $279/oz
> One median 2000 house: 428+ oz of gold
>
> Median house price in 2008: $210,000 (Natl Assoc of Realtors) <br/>Price
> of gold in 2008: $800/oz
> One median 2008 house: 262+ oz of gold
>
>
> Over the course of 38 years, an ounce of gold held value much better
> than a dollar did. You could easily buy a median house for around
> 450 oz of gold at nearly any point in that continuum, yet the number
> of dollars required for the same purchase increased by over a factor
> of 12.
>
> So recast your question: 30 years from now would you rather have
> 10 oz of gold or $9,000?

Jan 27 01:01 PM

[twitee:]

GOLD price/value is only related to dollar based on the strength of the US Economy and it power and credibility in the world.

At the present, there is no safer currency than dollar, but if the US economy does not recover soon...GOLD will be the safest currency in the world.

Gold will continue going up as long as US economy is getting worst. Gold will crash as soon as the US Economy and stability returns.

To validate my comments go back in history and corrolate the Gold price to the USA crisis.

Jan 27 01:10 PM

[Cesato:]

All comments are very interesting and somehow accurate in either trying to explain or predict the behavior in the Gold market going forward but they raise more questions than answers with regards to what the price of Gold is going to be within the next 2Q. I would not go that far because historically long term predictions only serve as a means to later explain why it did not happen. What is certainly true is that the price is setting itself up for a bull run very soon, how high? God knows, but seasonally Gold has taken off from Mid-Feb onwards, as long as the USD begins a downtrend, the correlation is there to stay, explanation? there may be many, including the actual cost of buying Gold with a cheaper Dollar and almost 0% interest rate or that historically when Yen based carry trades are heavily sold together with Equities that very same cash seeks refuge in precious metals, etc etc, all I can think of now is a technical base around USD 830 (you do the charting please) and then a bull trend established from there once EUR/USD begins going higher, if I did not think that the USD has no fundamentals to stay strong other than flows repatriation and a temporary fear that the ECB can go to 0% interest rates in an American like recession (which I don't see coming quite yet), then I would not dare to bet in a bull trend for Gold, but again Fundamentals for Gold including the speculative characteristic of this market plus the fact that there is so much cash sitting on the sidelines, make me believe in a bullish Gold for the first 2Q. Where to buy may be USD 830, where to add more Gold to your networth? probably USD 905 on the way back up, where to get out? probably USD 1200 in May 2009 to book your first profit and USD 1400 July 2010 for the second profit, beyond that is hard to say, but if the run goes above USD 1000 within the next 1 1/2 months and right away comes back down below USD 1.000 I would sell it all, the bullish case of this market has good fundamental and technical support at the moment but is very sensitivie to markets in panic due to its small size and the amount of cash that is getting into it. Please don't think that I'm one of those who believe they know the future based on whisful thinking nor do you take my comment as controversial, it's just what I think I'll do next month with an exit strategy if the price goes below USD 800 before the end of February 2009. I addressed some time ago the second round effect of the increasing Money Supply but I find it pointless to revive it at this time, because the Gold run will be more like an opportunity for real money to make some money while the Stock Market crashes twice a week and they know they can move this tiny Gold market easily with their huge amounts of cash, speculative somehow? yes, profitable at the same time? yes. I'll go for the profit even if I don't fully understand what will be going on. I tried to explain to myself Gold at USD 1.000 in 2008 looking into the inflation theory and really found no correlation, however I did found that the purchasing power theory may make more sense, I have my own empiric indication of the Gold Strengh, which is the GOLD/(EUR/USD) ratio. USD 1.000/1.6 = 625 it's never been 700 but it's getting close, it stands at USD 900/1.32 = 681as of today slowing decoupling from the USD for the bull run. As a final note, Authors please don't get to excited when Gold reaches USD 1.200, it's not gonna go to USD 5.000 so please be focused whent the time comes to comment an eventual USD 1.200 (it may come, it may not).

Jan 27 02:00 PM

[Larry House:]

It sure is easier to ask questions in article titles than to answer them isn't it?

Jan 27 02:27 PM

[Dave Wrixon:]

Gold is simply a haven when investors fear everything else including paper money. It is not a sensible hedge against inflation, but it makes a lot more sense when you are talking hyper-inflation. If stocks are producing real yields (inflation adjusted) why the hell would anybody place their earnings in unproductive bullion? However, when real yields on mainstream investments go sharply negative, which is bound to be the case if the economy is shrinking and the printing presses are rolling, then Gold can be an effective means of wealth preservation in the short-term. The effect is magnified by the almost inevitable development of a speculation bubble. However, if you hold past the point where the recovery becomes obvious, then you will incur significant losses as the bubble burst and the smart money pours back into the stock market.

Jan 27 04:08 PM

[huskerbob:]

The general idea of Chris B's theory makes sense. It doesn't have to work perfectly as an exact formula - who wants to do that kind of math! The idea is what matters. I would like to add that in addition to inflation concerns, the level of confidence in our government's economic policies and practices could be added to the formula.
The previous run-up in gold prices was a direct result of the mismanagement of our currency. People realized that with no direct link to the gold price, the only thing protecting the dollar was the government's self restraint. Scary!
But Volcker eventually restored confidence through severe discipline, the economy began the greatest expansion in history, and gold became an afterthought.
Now we are facing the same problems that spurred the previous flight to gold, only exponentially greater. LITERALLY exponentially greater! Inflation or deflation, the dollar is in trouble, and from the sound of things there is no political will to fix it. The upside limit for gold is unknown, but the downside for the dollar only ends at zero.

Jan 27 06:58 PM

[samerca:]

what happens to the price of GOLD if the dollar is devalued?

Jan 27 11:40 PM

[Conan the B...:]

Yellowhoard: Review your questions and responses thereto, you will find that most people will have moved on to other articles and will not return again. So if you place your question to another commentator after they have commented, the odds are good that it will be missed.

There isn't enough time to read everything or to answer all the questions that arise.

The only reason I'm making this comment is because I just left you another comment.

Take care.

Jan 28 03:10 AM

[auto44:]

In the end fear and greed will rule the day as it always does. Right now and rightfully so fear is on the side of the gold investor. It seems that it has been the only place to hide outside of cash lately. I suspect that over the next year or so greed and fear will run back and forth from asset to asset.
I think that a 10% portion of investable wealth is prudent for quite some time with a lot of cash. I know the purchasing power of the cash will dwindle against inflation, but risk is high at this time no matter where you look to invest. Dry powder is better than burned powder.

Jan 28 02:46 PM

[Conan the B...:]

Auto44: Do you think Volcker is there for window dressing only?

Jan 28 06:53 PM

[johnbee:]

Seems to me if you want to relate value to something meaningful it should be flour or tobacco or Mars Bars rather than Gold. Most of its value is a sham. At least the $ has a value reasonably relative to its GNP.

Feb 10 07:48 AM