Gold and Inflation

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Gold Can Perform Well in High and Low Inflation Environments

Why gold performs well in high inflation environments

Price inflation

One of the classic and compelling reasons to own gold is that it acts as a hedge against inflation. When a government debases its currency by creating more of it, the value of that currency falls vs. other currencies whose governments are not undergoing similar debasements. Since the supply of gold is limited and relatively constant, the increase in the amount of currency in circulation makes each currency unit worth less in relation to the each unit of gold. In such a circumstance, it is said the price of gold is rising. While it is true the price of gold relative to the debased currency increases, what is really happening is the value of the debased currency is declining.

When a currency declines in value vs. gold, the purchasing power of that currency diminishes relative to gold, making the prices of goods and services priced in the debased currency go higher. Since the price of gold relative to the debased currency also rises, goods and services whose prices are rising relative to the debased currency can remain affordable when priced in gold. It is from this circumstance that gold has earned its reputation as a hedge against price inflation.

Asset inflation

When central banks increase the money supply by printing more currency units, price inflation ensues as in the example above. Recent central bank monetary inflation has taken a different form. Rather than printing currency and distributing it into the economy, in recent years central banks have printed currency and purchased assets directly from banks, corporations and governments. This increase in the money supply does not directly result in an increase in the prices of consumer goods and services, because the currency printed ends up on the corporations and banks’ balance sheets from whom the securities were purchased. This results in asset inflation rather than consumer price inflation. When central banks print currencies and buy bonds and sometimes equities (as is the case with the Bank of Japan and Swiss National Bank) the value of those assets rise at a rate higher than they otherwise would.

The price of gold may not rise during times of asset inflation caused by monetary policy whereby central banks directly boost the price of target assets by purchasing them, unless gold itself is one of the central banks’ assets targeted for purchase. In recent years, central banks have spent trillions of dollars that they printed out of thin air to purchase mortgage-backed securities, equities, government and corporate bonds. The result has been an increase in the price of real estate, stocks and bonds. Because these assets rise during the monetary inflation, more capital is attracted to them, boosting their prices further.

Central bank purchases of gold have been limited to Russia and China, whose central banks have purchased the bulk of gold sold to central banks in recent years. The value of the amounts of gold these two central banks have purchased is in the tens of billions of dollars vs. the trillions of dollars spent by other central banks purchasing other assets. Hence, asset inflation stimulated by central banks may act to curb gold prices by making it less attractive when compared to the assets that the central banks buy as such assets have the financial backing of those central banks and gold does not.

Why gold performs well in low inflation environments

Inflation Higher Than Interest Rates

In addition to printing trillions of dollars to buy assets over the past several years, central banks have also lowered their interest rates to zero or into negative territory. This has the impact of making gold attractive, because even though gold doesn’t pay interest, its cost of storage may be lower than the loss of return on a negative yielding bond. In addition, if price inflation is flat or in the low single digits, a negative yielding bond is certain to decline in real value as measured by its purchasing power as long as there is a spread between the inflation rate and the yield on the bond. Gold experiences no such diminution in value in a low inflation/negative interest rate environment, making it an attractive asset in such an environment.

Political and Economic Uncertainty

Gold also does well when there is political or economic uncertainty, irrespective of the rate of inflation. Gold has been a monetary asset for thousands of years and has out lasted all currencies issued by governments making it a desired assets during times of political upheaval or uncertain economic times.

Failed Monetary Policy

The value of government fiat currencies are based on the confidence that people have in the monetary and fiscal policies backing those currencies. In recent years, the world’s largest governments have engaged in massive deficit spending supported by their central banks that printed currency to buy government bonds to fund such spending and to purchase other assets such as corporate bonds and stocks.

The efficacy of boosting asset prices in an attempt to stimulate the general economy through monetary policy has been limited as only those with assets benefit from the higher asset prices. As such, the failure to adequately stimulate the economy via massive asset purchases has encouraged central banks to increase their stimulus programs with little or no discernable benefit to the general economy. Continued stimulus has, however, artificially boosted asset prices to levels that appear to some investors as over valued. When stock and bonds are overvalued, gold may look attractive irrespective of the existence of any price inflation. Since the Bank of England, the European Central Bank, the Swiss National Bank, The Bank of Japan and the U.S. Federal Reserve have not purchased gold, it has not had the same stimulus applied to it as stock, bonds and real estate, making it attractive as under valued vs. the assets that the central banks have supported with their monetary policies.

The failure of massive central bank asset purchases to boost the economy may lead them to try ‘helicopter money” which might involve directly handing citizens and corporations with money to spend. The anticipation of such an extreme monetary policy would also make gold attractive because helicopter money would inevitably lead to more money in circulation. This would most likely lead to classic consumer price inflation caused by an increase in currency in circulation relative to the amount of gold.

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This article by BGASC is not, and should not be regarded as, investment advice or as a recommendation regarding any particular course of action.