­­Is gold a good hedge against inflation?

It is commonly stated that gold is a good hed­­ge against rising prices. People keep gold in their portfolio with the expectation that as inflation rises, their gold will rise in value too, shielding them from the erosion of purchasing power that is inflation. So does this relationship hold? Does gold protect against inflation? First let’s look at the data.

This chart plots the inflation rate against the return on gold (in AUD) in that particular year. For example the point right up at the top tells us that when the inflation rate was 10.10%, the return on gold was 129.55%. Using a simple yet powerful statistical technique called the coefficient of determination we can measure the portion of variance in the return on gold which is explained by the change (rise or fall) in inflation. First the good news. The trend line predicts that in general higher inflation coincides with a higher gold return that year and there is strong statistical evidence that this positive relationship exists (this is measured using a [only slightly] more complex statistical technique incorporating sampling distributions and t scores). However only 13.03% of the variance in gold’s return can be explained by the variance in inflation. In three different years when inflation was between 10.10% and 11.27% gold returned 130% (1979), -30% (1981)  and 29% (1982). Blindly investing in gold and ignoring the other factors that would have contributed to 86.97% of your return over 1971 to 2010 seems a bit risky doesn’t it?

Two things complicate our analysis. The first is that with gold you can only hedge against one type of inflation. Demand pull inflation occurs when there is an increase in aggregate (total) demand for goods and services in the economy relative to the aggregate (total) ability of the economy to supply said goods and services. Increased demand from people for the goods and services produced by the economy is by no means a bad thing. When people decide to spend more money on another person’s goods, the seller’s income increases. Everybody’s happy. The problem is where the government (or more specifically the central bank) decides to print money. There are a number of reasons that they might do this, but most often throughout history it is because the government cannot collect enough tax to finance its spending. They print money and use it to buy what they need, whether it be defence, infrastructure… whatever. The problem is the economy can only produce so much, this amount being called the natural rate of output. There are only so many workers, so many machines, and so many hours in a day to produce goods and services. The problem can compound itself after the government spends the money with suppliers, who then spend this money again, and the cycle continues. Suppliers (newsagents, mechanics, everyone) who were happily producing at their natural rate of output, now find people banging down their door if the government plays this cheap trick too often. Businesses may initially be happy to produce more, but they will only be able to maintain this for so long, and eventually realise that it is just as easy to raise prices as it is to work overtime to try and meet the demand. As prices go up people tend to buy less of stuff and eventually businesses find themselves producing at the natural rate again, no better off because even though they’re charging higher prices for their goods, everything else is now more expensive too.

If the government does this a little you might not notice. The reference to people banging down doors may seem like a little bit of an exaggeration, but this is precisely what excess money printing leads to in large enough bouts, and anyone who’s seen pictures of German waiters auctioning off meals atop a restaurant dining table will understand this. It is precisely this kind of abuse of power by the government that gold is supposed to hedge against. The idea is that gold as a currency cannot be cheaply printed by the government for it to spend. To increase the supply of gold many years of exploration and development must take place at great cost, and most governments don’t seem to have that kind of patience and long term vision anyways. Your gold is supposed to rise in price with the rest of the goods in the economy, leaving you “unexposed” to inflation, as opposed to someone who has held cash over the same period which has not risen in value (your ounce of gold is worth more but their ten dollar note still has a ten on it). It is a commonly known fact among economists that, in general, an increase in the money supply relative to the supply of goods and services in the economy causes inflation.

“Cost push inflation” occurs because of an increase in the cost of producing a good. When the Queensland floods wiped out much of the grain produced there, this supply reduction resulted in increases in grain prices, which ultimately flows through to food prices and gets counted in the consumer price index and inflation. Gold cannot be a hedge against this type of inflation. A good becoming scarcer will cause its price to rise regardless of the type of money used (assuming its demand remains constant). So somehow we need to separate the effects of demand pull and cost push inflation if we are to compare against gold returns. No easy feat.

The second problem we have is that super-efficient gold markets price in future inflation as soon as they get a whiff of it and increase their demand for gold immediately (throwing up its price).

The second problem we have is that professional gold traders jump into gold (increasing its demand and hence its price) as soon as they get a whiff of any inflation that might occur in the future, trying to beat the rest of the market. This happens well before inflation hits the average man down the street talking about how he used to be able to buy a cup of coffee for ninety cents, and well before the inflation shows up in the data. So comparing the gold return to inflation in the same year may be pointless! One way to account for these problems is to compare the gold return to increases in the money supply, which signals to the market future demand pull inflation. The following chart does just that.

Although the trend line predicts very mild increases in gold returns as money growth (represented by Broad Money, but that’s an article for another day) increases, this time there is no statistical evidence from the sample that a positive relationship exists between the two, and only 2% of the variation in gold returns is explained by variation in the money supply growth. So what else explains the movement in the gold price?

What else explains the movement in the gold price?