Why Inflation Isn't Affecting Gold Prices

Includes: GDX, GDXJ, GLD, GOLD
by: ChartProphet

The often-used argument by Gold Bugs has been that the Gold price, if adjusted for inflation, is still considerably below the highs of the early 1980s. And since we are still below the early 1980s prices, we should not be concerned about a gold bubble. Even more, the argument claims that since we are well below inflation-adjusted record prices in gold, we can expect gold prices to continue to run up significantly before a peak is in place. In other words, they claim that $1400 gold is still not expensive because $1400 in 2010 is worth less than $700 in the early 1980s.

Take a look at the following chart:

As you can see, Gold adjusted for inflation is at a lower price than it was in the early 1980s. The reason behind it is that a dollar can buy you less today than it did 30 years ago, due to inflation. And a good way to measure that inflation and see how it affects the average consumer is through the Consumer Price Index (CPI). The CPI, which measures the price of a basket of goods and services purchased by households, has been rising fairly steadily over time. Since 1982, when the CPI was indexed at 100, we have seen it more than double to our current level of around 220; that means that the dollar today can buy you less than half of what it was able to buy in 1982. And if we take the buying power of the dollar into account, we can see how gold could be priced at $700 in 1980 and $1400 in 2010.

But I have a few problems with that argument:

1) Gold price records of 1980 came at a time of soaring inflation. Inflation was at 13.5 percent in 1980! Compare that to 2009 where we had negative inflation, and to 2010 where we’re averaging less than 2 percent inflation so far. Since inflation “inflates” prices, it is understandable how gold prices skyrocketed in the early 80s in order to reflect the surge in overall prices. But at a time when prices are actually struggling to increase, and are threatened by disinflation (which would see prices rise at a low rate, or not even rise at all), can we really justify soaring gold prices?

Take a look at the chart:

As you can see, the 1980 gold price high was accompanied by huge percentage increases in the CPI. And over the next 25 years, gold prices were generally stable as the CPI grew between 1 and 6 percent annually. But starting in 2005, we all of a sudden have a huge divergence between gold prices and the CPI. In other words, we would expect gold prices to rise and fall in accordance with changes in the CPI – if the CPI soars we would expect gold prices to rise as well, and if the CPI falls we would expect gold prices to fall or at least grow modestly. But that’s not the case here; the gold price surged together with CPI in 1980, but is completely diverging from CPI since 2005. If anything, we should be seeing gold prices stagnate or even drop a little to match slowing inflation.

2) Largest divergence between real gold prices and inflation-adjusted gold prices. Not only are gold prices diverging from the yearly CPI changes, but they are also diverging from themselves.

Take a look at the chart:

While real gold prices and gold prices adjusted for inflation have generally remained close, they have diverged from each other to a huge extent since 2005. In the early 1980s, the two prices were almost identical, and even overlapped. But in 2010, we have real prices at $1400 while the inflation-adjusted price of $644 lags by over 50 percent. Either the inflation-adjusted price has to catch up, or the $1400 real gold price has to drop. With such a massive and unprecedented divergence between the two, I’d bet on option B.

3) As CPI is up less than 30 percent since 2000, gold is up over 350 percent. If CPI is a good measure of overall inflation, we’d expect prices of most items to increase, or decrease, in accordance with changes in the CPI. Therefore, if the CPI increases by 30 percent, we’d expect most items to increase in a range around that 30 percent; prices of food may rise 35 percent, but prices of energy could rise only 25 percent, for example. But when we see the price of one item increase by 350 percent, as gold has in this case, we should question whether such a move is really justified as prices of the rest of the things we could buy are not even close to moving that rapidly.

Take a look at the chart:

As CPI has essentially flat-lined since 2005, gold is up almost threefold.

In conclusion, though we have not surpassed the record high price of gold in 1980 when we adjust for inflation, we have certainly doubled the record in real prices, we currently have no soaring inflation that would justify the huge price moves (as it did in 1980), we have the largest divergence ever between real prices and inflation-adjusted prices, and our disinflationary threats (as evident by the stagnant CPI changes) should actually be slowing price increases rather than accelerating them. In other words, gold is moving much faster than inflation, and maybe even too fast.

See my article “Gold Bubble: Final Warning?” for a complete breakdown of why the gold move may be overextended.

Disclosure: Short GLD