What else explains the movement in the gold price?

The argument regarding gold and inflation stems from the notion that throughout history gold has been used relatively consistently as currency to facilitate transactions. Gold does this well because it is portable, hard to forge, is highly resistant to corrosion (so it won’t rust on you) and has a relatively stable supply. This means it performs the functions of money quite well, and makes gold a prime candidate for an alternative currency, should an economy lose faith in the present fiat one. Inflation has crippled many, if not all fiat currency regimes in the past, hence the idea that if we have inflation gold should become more valuable. But inflation is just one of the phenomenon that can lead to the loss of faith in a currency. Does this imply a one for one increase in the gold price as inflation rises? Probably not. If prices rise by three percent over 2010, is your gold worth three percent more? In fact the gold in your portfolio isn’t worth anything (ignoring the few industrial uses it has) until the day the world throws away its paper money and goes back to using gold for transactions. Holding gold is about waiting for this day, and gaining a huge return, rather than trying to hedge against the steady rise in inflation.

The inflation hedge argument breaks down where people decide what to do with their increased holdings of money. It assumes that a little bit of the new money finds its way into everything you buy. You buy a little more food, a little more television, and a little more gold. When the money supply increases, people buy goods and services from the storeowner because they want to use them.  But why buy gold? Why not put your money in a bank account and earn interest if you don’t want any goods and/or services right now? The only answer is because you fear that the fiat currency system that your money would be part of (in a bank account) is going to fall apart, and gold will become the new medium of exchange.  This is likely what explains the other 87.38% of variation in the gold price (as well technical traders chasing trends, herd mentality etc). The jury is still out on exactly how damaging inflation is for an economy or financial system, but a three percent increase in prices over a year is probably not going to tear it apart and result in an increased risk of holding money, resulting in people demanding gold and pushing up its price. Consistent increases over time? Perhaps, however some economists are adamant that a little bit of inflation is good for the economy. But that too is an article for another time (and a controversial one at that).

So does the data support this conclusion? Below is a chart showing the price of gold with a blue line, and the inflation rate with red bars. It shows that the price of gold increased quite dramatically from 1971 to 1980. Over this time inflation was quite high. Yet from then on until 2000 the gold price did little, hovering around $500 for twenty years, even though inflation over this period persisted (albeit at a reduced level). The gold price then took off and was just under fourteen hundred dollars by 2010, rising sharply throughout a period of moderate inflation.

Two things need to be remembered about the 1970s. The first is that a significant portion of the inflation is cost push inflation (against which gold cannot be a hedge) attributed to the energy crises scattered throughout the decade. The second is that 1971 was the year of the “Nixon shock” where conversion of US dollars into gold was abruptly suspended. Under the Bretton woods exchange rate system every country could, at predetermined rates, exchange their currency for US dollars, and then their US dollars for gold. When central banks and citizens alike became suspicious of the US’s ability to do this (due to large scale increases in the US money supply) they began to lose faith in the global monetary system, and demanded their currency be exchanged for gold at the federal reserve. As the US began to run out of gold to exchange for its currency it announced it would cease to do so and the demand for gold (and its price in the private market) skyrocketed. Excluding the war years, money had been backed by gold for centuries, and the evaporation of this backing left nations not worried about inflation, but about the legitimacy of their currency.

The parabolic increase in the gold price between 2000 and 2010 occurred when average inflation was just 0.86% higher than the decade before, where gold did nothing. In fact towards the end of the decade deflation was the greater concern as the world plunged into recession. This event did however shake the globes confidence in the financial system and its currencies, as did the dot com crash and the World Trade Centre attacks in the early 2000s. It is these types of events that shake the confidence in the current financial system and the unbacked paper currencies it rests upon that give gold a fundamental value. Gold is not a hedge against inflation, but a hedge against the possibility of people seeking an alternative to their fiat currency.

Of course history is always up for interpretation, and this is mine. There are bound to be others. But just remember that blindly investing in vesting in gold as a hedge against inflation blindly goes against all logic. Know exactly what your investment goals are with every trade. Now I know what you’re thinking: I’ve read this whole boring article on inflation. You’ve told me what not to invest in. Tell me something I can use! The answer might be more boring than you think.

The evil, ever present, value eroding effect of inflation on...Game shows!