How effective is gold as an inflation hedge?

If you go to almost any source for reasons to invest in gold, one of the first reasons it cites is for an inflation hedge.  A quote from the World Gold Council (one of the most reputable sources of information about gold) is typical, “Investors often rely on gold to counter the effects of inflation.”

In the spirit of challenging embedded assumptions, I decided to probe deeper to determine just how effective gold is as an inflation hedge.  Just because every purveyor of precious metals cites this “fact” and many market pundits echo this assumption, it does not mean that their assumption is based on accurate data or reflects an accurate interpretation of history.

Let’s take a look at the historical price of gold and see how closely it tracks the inflation-adjusted value of a currency, which is what you want from a true inflation hedge.  I compared the price of gold from the time President Nixon ended the last link from the dollar to gold in the early 1970s to the consumer price index as published by the Bureau of Labor Statistics. During the 1970s, inflation raged and the gold price soared.  Correlation between the two data sets was high.  However, gold increased at a much faster rate than inflation.  The price index approximately doubled, while gold went up by a factor of 14.  Adjusting for the reduction in the value of the currency means that gold was roughly 7 times its value at the end of the decade compared to the start.  Gold did much more than merely provide a store of value.  Its price increased at a huge multiple to the currency it was hedging against.

The situation dramatically changed in the 1980s, though.  The consumer price index continued to march ahead and during the decade prices increased another 64%.  This was lower than during the previous decade, but still quite significant.  At this rate of inflation, the dollar loses half its value in a little more than 15 years.  Gold prices went in the other direction, though.  They fell by 22% in nominal terms (before any inflation adjustment).  After adjusting for inflation, gold lost 53% of its value.  So unlike in the 1970s, prices in nominal dollars kept increasing, but gold decreased.

In the 1990s, prices increased by a further 33%.  Gold’s nominal price decreased by another 27% and its inflation-adjusted value went down by 45%.  For the second consecutive decade, gold provided no hedge against inflation.  For both periods, you would have been better off keeping your money in a mattress than investing in gold.

In the 2000s (through the present), the situation has reverted to something closer to that the seventies, although the rate of inflation is much lower.  From the beginning of 2000 to the end of March 2012, the price index has increased by 36%.  Gold’s price in nominal dollars has increased by a factor of about 5.7.  Adjusted for inflation the increase is by a factor of 4.2.  This is not quite the same magnitude as during the 1970s, but it is still quite a significant increase.

Note that the inflation rate during the 1990s and the period from 2000 to the present has been roughly the same.  (The 2000s include more years, so the inflation rate since 2000 is actually slightly less than that of the 1990s.)   But in one decade, gold declined quite dramatically and in the other decade (plus a few years), gold rallied strongly.

When I examine data like this, I have a very difficult time seeing the relationship between gold’s price and the inflation rate that one should expect from an inflation hedge.

Some investors would argue that today’s inflation rate is not the key statistic, but tomorrow’s is.  They cite the Fed’s easy money policies and increase in the money supply as harbingers of future inflation.  Ignoring for a moment the futility of accurately trying to predict future inflation rates, one should ask how much future inflation is already “built into” the price of gold from price increases during the 2000s.  For the last seven years, gold prices have increased at an annual rate of 21% per year.  Inflation has increased by 2.5% per year.  We could have more than 10 years of 10% inflation before the price index catches up to where gold was seven years ago.

Another data point that contradicts the “gold is an inflation hedge” theme is the high correlation between gold and long-term bonds for the last five years.  Long-term bonds are the worst asset class to be holding in an inflationary environment.  They have the most sensitivity to interest rate increases, and will be impacted the most by a decline in the value of the currency.  So you would expect a true inflation hedge to be inversely correlated with long-term bonds, not highly correlated.  But gold has had a higher correlation with long-term bonds than any other major asset class over the last five years.  This has been termed the “fear” or “risk off” trade, when investors buy gold and government bonds and sell just about everything else during times of extreme stress, such as during the stock market crash of 2008-09.

So, if you own gold because of its characteristics as an inflation hedge, you might want to rethink this.  It is just another myth that can trap the unwary investor.

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