Gold and Deflation: The Never-Ending Discussion

by: Przemyslaw Radomski, CFA

Two of the questions that we've received in the past weeks were about gold's performance under deflationary scenario.

Generally, there are two opposing theories - one says that gold will fall just like every other asset during a deflation, while the second suggests that gold - being the ultimate form of cash - will thrive during a deflationary scenario. Let's begin by defining a deflation as a decrease in the general price level caused by a decrease in the money supply. The M3 money supply does indeed decline at this point.

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In order to check arguments of both sides (is deflation bullish or bearish for gold) we should keep in mind the simple fact that we live in the world of fiat currencies - not backed by gold. Gold's value rose in the past during deflationary scenarios, as it was in fact cash. This is not the case right now, so this argument will not hold true under normal circumstances. However, it might become important during very serious financial turmoil periods, when the idea of fiat currency system will be widely questioned. We are far from this point in our opinion.

So, does gold go down in a big way? Not really. Given the current political environment, it seems that any deflationary scare will result in "stimulus packages", "quantitative easing" and other forms of injecting money into the economy, inevitably resulting in higher gold prices. Besides there can be other factors that could contribute to gold's rally - not only the increase in the money supply - for instance war tensions.

Of course, the negative M3 growth at this point may suggest temporarily lower prices, but that is in tune with what we've already written in this update. We don't think that it would mean the end of the current bull market in the precious metals - not until gold reaches $3000, or most likely $5-6000 or so (in today's dollars).

Disclosure: No positions