Saturday, December 27, 2008

Is gold a hedge against inflation?

There are problems with using gold as an insurance against inflation.

1. Governments interfere with it - from making it the legal base of their currency, as in the US Constitution, to making it illegal to have any, as in the US in 1933; from guaranteeing the exchange rate of gold against the dollar (post WWII) to the Nixon Shock of 1971, when the gold window was closed.

2. Central banks claim to hold it, then (it is widely suspected) lend or sell it surreptitiously.

3. There is so little of it, that speculators can have a significant effect on the price, especially if (as appears to have happened in recent years), the speculation has been powered by vast amounts of borrowed money.

Below, I give three graphs, all comparing the price of gold per ounce in US dollars with inflation as measured by the Consumer Price Index (and that's another can of worms). It's clear that gold has a very volatile relationship with inflation and can spend a very long time above or below trend.

In the fourth graph I divide the Dow by the price of gold. It seems obvious that gold is a contrarian position for equity investors, rather than a simple hedge against inflation.

Currently, the Dow has come back to something like a normal ratio to gold, but past history suggests there will be an overshoot. And gold itself seems above trend over all three periods chosen; which suggests that both still have a way to fall in nominal terms, but the Dow more so.

(N.B. gold prices to the end of 1967 are annual averages, then monthly averages to the end of 1974, then the price is as on the first trading day of the month; all gold price figures from Kitco).


Nick Drew said...

after 2 years' observation I have formed the view gold is a hedge against Bad News (the glaring exception being when Russia invaded Georgia - but other Strange Things were happening at that time)

it clearly hasn't been behaving like a commodity, which some folks maintain is all it is

if/when deflation and/or negative interest hit, one of the standard arguments against gold goes away - namely that it has a (small) 'negative coupon': just about everything starts to have a cost-of-carry too, even cash when you start having to pay the bank for safe-keeping

Sackerson said...

Hi Nick, and thanks for the observation. Have a good Chrimbo?

hatfield girl said...

Gold is a mask for fear and ignorance. Gold holders are those who lose their confidence in understanding what is going on, and faith in their ability to forecast what is going to happen next.

If the world doesn't come to an end, gold will lose its value; if it does come to an end, it's useless.

Sackerson said...

I's still call it a contrarian investment, rather than useless, HG - look what would have happened had an investor sold the Dow and bought gold at the end of 1999.

Nick Drew said...

Yes, a good time thanks Sackers

some gold-holders may have lost their confidence & faith etc HG (who is still wholly confident ? though I shall try my hand at New Year as before): but what of the confident forecaster who picks gold ? a reductio here somewhere ...

(predicting a flight to gold is as valid a guess as any other)

as regards the world ending, timing is everything ! and in the meantime I may need to lay up some riches

and after it ends ? so far as I can tell in advance I am not a suicide, & we are urged to build arks, are we not ? though of course they laughed at Noah !!

clean water etc etc: and for trade ? what do people trade when they have nothing ? - rather gold coin, than be forced to hand over something more precious still

AntiCitizenOne said...

The ultimate hedge is security.

Who has the biggest stick?

Mark Wadsworth said...

In the very long run, yes. In the short term, no.