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The Bullion Report

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September 29, 2010 in 'The Bullion Report'

Inflation & GoldInflation & Gold

9-29-10

Inflation & Gold


When it comes to the gold markets, it is not uncommon for investors to hear the word inflation from time to time. Gold is generally talked about as a potential hedge for inflation. On the other hand, there are economists who argue that it is a poor hedge for inflation. Others still point to inflation as a potential catalyst for higher gold prices and argument for new price heights. So what is the backbone of this argument and how does inflation work into the gold markets?

 
Past performance is not indicative of future results.
***chart courtesy Gecko Software’s Track n’ Trade Pro


In plain terms, inflation is the word to describe the rise of prices of goods and services in a particular economy. Usually, this price gain happens over a stretch of time. It can also be described as the erosion of the value of money. In the United States, inflation is characterized by the fact that it takes more dollars to buy certain goods and services than it did when compared to a another time period. The classic story from older generations about the cost of bread or a nickel buying a chocolate bar is a reflection of inflation. A dollar just doesn’t buy what it used to.

These changes in the purchasing power of a dollar are reflected in a price index like the Consumer Price Index (CPI) from the Bureau of Labor Statistics. This index measures the “average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.” These urban consumers are roughly 87 percent of the population. The goods included cover everything from food, apparel, and housing to transportation, medical care, and education. Obviously, this covers the majority of products and services that the average individual needs to concern themselves with.

Many economists suggest that inflation should happen at a slow and steady rate. Positives for a low rate of inflation include the Keynesian idea that it might soften the blow of recession where the labor market is concerned. However, the root issue that has recently been grappled with is that there is potential for it to accelerate because of the general response to the recent credit, housing, and banking crisis. This would be more in tune with the monetarist view.  All of the rapid printing of money and the large stimulus packages from governments has likely increased the money supply. A catalyst for inflation is the devaluation of money and there is no better way to see a currency’s value plummet than to add debt or increase supply. What many investors are looking for is a moment of hyperinflation.  In their estimation, gold performed well enough against the high prices seen in the 1970s, if recent events push prices higher it may perform just as well.

The effect on gold because of the fear of instability has been substantial. Recent movements have pushed gold prices to record highs, topping $1,300 per troy ounce. This has been partly due to the desire for a haven or store of value during particularly harrowing financial times, as well as the demand for a hedge. The common argument against ownership purely on the basis of hedging against inflation suggests that the downtrends in prices during the 1980s and 1990s would have been rough on gold bugs. However, the other side of the price argument suggests that there is plenty of upside potential for gold prices specifically because they have not really reached new highs when viewed through an inflation microscope.

According to recent news headlines, the fact that the price of gold has only gained about 19 percent this year while “consumer prices have almost tripled in the past three decades” is proof that it isn’t keeping pace with inflation. (1) It is argued that the $873 peak price of gold in 1980 would be over $2,300 an ounce today, based on the Bureau of Labor Statistics’ inflation calculator. That calculator is based on the average CPI for the given year. This calculation would mean that gold has another $1,000 per troy ounce to go before it approaches the inflation-adjusted high.

That kind of logic coupled with the idea of an increasing money supply due to the economic crisis could be the catalyst for continued bullish views on gold. It is not just the United States that has increased debt in an effort to stave off a credit disaster. The European banks and other western powers have been scrambling just as hard to try to salvage the situation and that means a global increase in money supply. Inflation and the threat of paper money being devalued to the point of hyperinflation are very real to some analysts. It is a concern that has been back-burnered by governments trying to prop up recovery.

Summary

Does the purchase of gold as inflation insurance hold water? Gold doesn’t offer any kind of cash flow over time like interest payments. Storing it might even cost you money. However, the price risks associated with gold vary enough from other investments to offer a reasonable alternative during times of crisis. If the response to the crisis is to print more money and increase debt, then gold could be the alternative to that paper money. If it is an alternative to the fiat currency, then the investment demand of bullion could naturally provide a hedge against that crisis response. After all, no one person can guarantee a store of value but it is unlikely that gold, as a commodity, would see the whole of its value eroded by inflation the way that other savings might.

True gold fears no fire. -CHINESE PROVERB

1 http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a3w9OGzFRe3Y

 


Disclaimer: The prices of precious metals and physical commodities are unpredictable and volatile. There is a substantial degree of a risk of loss in all trading. Past performance is not indicative of future results.