More Thoughts on Gold and Inflation

Includes: GDX, GLD
by: Josh Hendrickson

I recently agreed to have some of my posts reproduced over at Seeking Alpha. Wednesday’s post on monetary policy is one such post. In the comments, I was sarcastically criticized as, among other things, advocating a policy that would lead to gold selling at $12,000 an ounce. I am not concerned with the criticism, but rather the broader point implied by the comment that monetary policy is driving gold prices higher. While I think that gold can reasonably reflect inflation over the long term, I would caution against inferences that the current increases in gold are the result of the Fed’s monetary policy. These increases have more to do with secular forces than with monetary policy.

Let’s examine the characteristics of the gold market. Gold has three uses on the demand side: (1) an investment hedge against inflation, (2) jewelry, and (3) industrial uses. On the supply side, there is an existing (stock) supply and a flow supply generated by mining. Changes in the stock supply of gold are most often the result of central bank behavior.

To argue that the increase in the price of gold is the result of monetary policy, one would have to be able to show that policy is loose and that the increase in the price of gold is being driven by investment demand. Readers know that I don’t think that monetary policy is too loose. I will not rehash that argument. However, let’s examine the gold market.

Over the last 5 years or so, we have seen the following changes:

  1. Central banks have reduced the amount of gold that they are selling.
  2. Gold ETFs have increased the demand by purchasing gold for storage.
  3. Gold mining output peaked somewhere around 2001.

Supply declines. Demand increases. Price increases.

I don’t see how this has much to do with monetary policy. In fact, bearing in mind that nominal income is below what anyone would believe to be a reasonable target and the fact that inflation expectations — measured by TIPS or economic forecasts — are less than or equal to 1.5%, it becomes even harder to imagine that rising gold prices are the result of expected inflation. And there is the fact that consumer prices as measured by the Personal Consumption Expenditure Price Index have been falling (-1.87% at an annual rate for the month of October and -3.6% for the month of September; HT: Ritholtz).

Then again, maybe gold is rising on expectations of higher expectations.