Seeking Alpha

A new high gold price always revives talk of its inflation-adjusted price. The most common inflation-adjusted measure is the CPI, using the 1980 high price of \$850. The problem with using the CPI is that the use of hedonics, substitution, and the removal of food and energy eliminate most of the price increases. In addition, since inflation is a monetary phenomenon, any inflation adjustment must be against changes in the money supply. The only true way to inflation-adjust the gold price is against the currency supply.

The Gold Standard Act of 1900 defined the dollar as a weight of gold and set the dollar’s value at 1/20.67 ounce of gold, later revalued to 1/35. In other words, for every one ounce of gold, there was \$20.67 in currency. Mathematically, the currency/gold ratio is expressed as the currency supply divided by the ounces of gold a country owns. Examining the gold price and the currency/gold ratio since 1900 shows the gold price and the currency/gold ratio equal over time.

The table below illustrates the changes in currency supply, US gold holdings, Gold Price, Currency/Gold Ratio and difference between the price and currency/gold ratio.

 Year Currency Supply (in Billions) Gold Holdings (in Millions) Gold Price Currency/Gold Ratio Difference between Gold Price and Currency/Gold Ratio 1900 \$1.19 44.97 \$20.67 \$26.48 28.11% 1905 \$1.48 59.99 \$20.67 \$24.60 19.01% 1910 \$1.73 80.30 \$20.67 \$21.59 4.45% 1915 \$1.98 97.96 \$20.67 \$20.16 -2.47% 1920 \$4.49 127.67 \$20.67 \$35.14 70.00% 1925 \$3.96 198.93 \$20.67 \$19.93 -3.58% 1930 \$3.81 208.32 \$20.67 \$18.28 -11.56% 1935 \$4.88 289.28 \$35.00 \$16.87 -51.80% 1940 \$7.28 630.00 \$35.00 \$11.55 -67.00% 1945 \$20.26 573.82 \$35.00 \$45.66 30.46% 1949 \$25.20 701.80 \$35.00 \$35.91 2.60% 1955 \$27.80 621.50 \$35.00 \$44.73 27.80% 1960 \$29.30 508.68 \$35.00 \$57.60 64.57% 1965 \$36.70 401.85 \$35.00 \$91.33 160.94% 1970 \$49.50 316.33 \$35.00 \$156.48 347.09% 1975 \$74.10 274.69 \$139.30 \$269.75 93.65% Oct 1979 \$103.80 264.60 \$391.65 \$392.29 0.16% Jan 1980 \$105.10 264.31 \$675.30 \$447.91 -41.12% May 1981 \$118.30 264.11 \$479.25 \$503.80 -6.54% Jan 1983 \$132.50 263.37 \$499.50 \$503.80 0.86% Apr 2011 \$942.50 261.49 \$1,500 \$3604.22 144.04%

As the table illustrates, the gold price and the currency/gold ratio can diverge, sometimes dramatically. However, the gold price and currency/gold ratio are always equal over time, regardless of increases in the currency supply and changes in the number of ounces of gold in reserve -- thus making gold a hedge against inflation over time.

For example, in 1915, the gold price was \$20.67 and the currency/gold ratio was \$20.19. In 1920, to pay for WWI, the Federal Reserve Bank increased the currency supply 127%, and the difference between the gold price and currency/gold ratio increased to 70%. Following WWI, in 1925, the Federal Reserve Bank decreased the currency supply, which aligned the gold price (\$20.67) and currency/gold ratio (\$19.93). The same divergence can be seen in 1945, 1965 and 1970.

Two of the most striking alignments are from 1915 to 1949 and from 1949 to 1983. From 1915 to 1949, the currency supply increased 1,176%, the gold holdings increased 616% and the gold price and the currency/gold ratio equaled. Even more interesting is a comparison of 1949 to 1983, because for 12 of those 35 years, gold traded on the free market. From 1949 to 1983, currency increased 425% and gold holdings decreased 62.5% and the gold price and the currency/gold ratio equaled. From 1900, the gold price and currency/gold ratio have been within 10% of each other 20% of the time (251 of the 1,253 months).

There are also times when the gold price is higher than the currency/gold ratio. The first example was between 1930 and 1940, and was corrected by an increase of gold reserves. The second, on Jan. 21, 1980, saw the gold price of \$850 as 214% higher than the currency/gold ratio of \$397.25, and was corrected by a decrease in the gold price.

Examining today’s gold price (\$1500) and currency/gold ratio (\$3,604.22) shows a divergence of 144%. Since the gold price and currency/gold ratio equal over time and have been within 10% of each other 20% of the time since 1900, they should equal in the future -- which makes \$3,604.22 the true inflation-adjusted gold price.

However, since the Federal Reserve Bank’s increases, the currency supply on average is 11.5% each year (since 1971, prior to 1971, 8.5%). The currency/gold ratio, and the inflation adjusted gold price, will change every year. The chart below illustrates the increase in the currency/gold ratio, and corresponding manic gold price (the inflation-adjusted 214% higher than currency/gold ratio), each year to account for a conservative 10% increase in currency.

 Year Currency/Gold Ratio Manic Gold Price 2011 \$3,829 \$8,194 2012 \$4,212 \$9,013 2013 \$4,633 \$9,915 2014 \$5,096 \$10,906 2015 \$5,606 \$11,997 2016 \$6,167 \$13,197 2017 \$6,783 \$14,516 2018 \$7,462 \$15,968 2019 \$8,208 \$17,565 2020 \$9,029 \$19,321

In conclusion, the inflation-adjusted gold price today is \$3604.22, and the inflation-adjusted 1980's price of \$850 is \$8194. These prices will change each year to account for currency inflation. The actual inflation-adjusted prices will depend on how fast the gold price increases and could very well reach \$5,000-10,000 on an inflation-adjusted basis.

Disclosure: I am long CEF, GLD, PHYS.