Some gold market participants draw a connection between money supply, inflation, and gold. The view is often expressed that excessive creation of money by central banks ultimately must lead to inflation, and that inflation must ultimately be reflected in higher gold prices. While there are empirical connections among these variables, the actual relationships are far from being constant and carved in stone. Excessive money supply does not necessarily lead to inflation. It can, but the history of the past three decades suggests that the inflationary consequences of excessive money supply creation can be obviated by later corrective policy actions by monetary authorities: Selling bonds to sop up the excess money if and when it begins to have an inflationary impact. So, too, the relationship between general price inflation and gold prices is far from being one of lock-step moves.
Money Supply and Inflation
Looking more closely at these factors it becomes apparent that there are no significant statistical relationships among them. The relation between money supply and inflation can range from being inverse to being positive depending on the time lags being used. For the purpose of studying this relation U.S. M1, U.S. MZM, and U.S. inflation were used. U.S. data was selected because it provides a long time series (monthly data since 1981), its economy has accounted for around a quarter to a fifth of global gross domestic product over that period, and the majority of wealth in the world is held in dollar denominated assets.
When there is no lag between the data points of U.S. MZM and U.S. inflation, the correlation is -0.14. When lags were introduced (the impact of money supply today on inflation at a later point) the correlation remained negative at -0.12 with a one year lag and turned immaterially positive at 0.01 with a two-year lag. The correlation became positive at 0.12 with a 3.5 year lag. The correlation gets stronger with a four to four and a half year lag, getting as high as 0.32. That said, this is still not a strong relation. The correlation begins to weaken again with a five year lag.
The correlation between U.S. M1 money supply and U.S. inflation was stronger than the relation between MZM money supply and inflation. Incorporating no lag in the two data series resulted in a -0.04 correlation, which turned mildly positive to 0.10 with a one year lag and to 0.24 with a two year lag. Though these are stronger correlations than those between MZM and inflation, they are still statistically weak. These figures suggest that there is a weak positive relation between money supply and inflation. Also, the relationship begins to weaken beyond a point, five years based on the data being studied, which tell us that central bankers can and have effectively in the past controlled the inflationary consequences of increased money supply.
Studying OECD M1, a gauge of narrow money supply in the 34 member countries of the OECD that account for around 75% of global gross domestic product, grew at an 8.9% annual rate between 2008 and 2012. OECD M3, a gauge of broad money supply in these countries, meanwhile grew by only 5.2% per annum between 2008 and 2012. These numbers suggest that a large portion of the money that central banks have introduced into the global banking system over this period is not being lent or spent aggressively.
Inflation and Gold
Gold is regarded as an inflation hedge. It has acted as a hedge against inflation during certain periods but has not performed well as a hedge against inflation during other times. The criteria for when gold has performed as a good inflation hedge and when it has not has been based on the increase in gold prices and increases in U.S. inflation. If the increase in gold prices has kept pace with or exceeded the increase in inflation during a particular period then gold has performed as a hedge against inflation during that period. If the price of gold has not kept pace with inflation or has declined during a period of economic inflation, then gold is considered a poor hedge against inflation in that period.
The data being studied is between 1968 and 2012. During these years, inflation in the U.S. rose sharply in the following periods: 1972-1974, 1976-1980, 1986-1990, 1998-2000, and 2002-2012. The price of gold rose more strongly than inflation between 1972-1974, 1976-1980, and 2002-2012. It has therefore been a successful hedge against inflation during these years and has been shown in blue shading in the chart below. The price of gold meanwhile declined between 1986 and 1990, and 1998 and 2000, periods when inflation was rising. Gold was not helping to hedge against inflation during these periods and has been shown in red shading in the chart below. Examining this data tells us that even as gold has acted as a hedge against inflation it is not always the case.
The gold rally between 2002 and 2012 has been one of the longest and strongest in the history of gold. There are a multitude of factors that have driven gold prices higher in recent years; one of which has been the expectation of a sharp increase in future inflation based on the increased monetary accommodation by central banks around the world following the Great Recession of 2008-2009. Actual inflation post the monetary accommodation has been fairly contained, however. Nonetheless the price of gold has risen sharply in part on expectation of higher inflation, which may never come. Unemployment levels also are high in other developed economies. Constrains on consumer spending resulting from this is expected to keep inflation in check in all developed economies.
There are two sets of factors that drive general price inflation: Monetary trends and real economic trends. In the real economy, the world is awash with surplus labor and industrial capacity utilization in developed countries has not reached levels which would promote inflation. These factors are disinflationary, if not deflationary, and are offsetting inflationary pressures in energy, medical care, and other sectors of the global economy. In the monetary realm, while monetary authorities have been pushing a great deal of cash into their economies, to date these accommodations have not resulted in higher inflation and, if in the future they start to appear to be turning inflationary, monetary authorities expect to sterilize their inflationary implications by selling bonds to reduce the excess cash in circulation.
Between 2009 and 2011, investors drove gold prices sharply higher in part based on expectations of sharply higher inflation in the future. Based on current global economic conditions and the lack of any threat from inflation so far in the developed world, some investors are beginning to realize that inflation may remain contained and that if it rises at some point in the future it could be contained by the Fed selling bonds back into the market. This could result in the inflation premium in gold prices coming off over the next few years, which is expected to weigh on the upward potential of gold prices (GLD) in the future. A variety of factors could help gold prices remain at elevated levels and even rise, but inflation may not be one of them.
- There isn't a statistically significant relation between money supply and inflation. It should not be assumed that an increase in money supply with increase inflation.
- Gold acts as a hedge against inflation but not always.
- Markets over factored future inflation into the price of gold between 2009 and 2011. Some of that premium has come off but there could be more.
- Inflation in developed countries will rise at some point in the future but it is unlikely to be a case of hyperinflation.
- The lack of inflation premium in the future is expected to cap the upside potential of gold prices.
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