Gold and Inflation: How Strong is the Relationship?

For the past five to ten years we have been bombarded by commentary that gold is a hedge against inflation, and that wise, prudent, sensible people invest in precious metals in order to protect themselves against the out-of-control behavior of government officials. People like Marc Faber are frequently on air and cyberwaves, touting the idea that since central banks are inflating money supply, it is time to stock up on gold which is the only asset in the world that has real value, implicitly implying that it is more resilient to speculative activities, and socialist governments. Read on, we promise to present some surprising facts in this article.

Invest in gold to protect yourself against inflation

So be wise, and invest in gold to protect yourself against inflation, we are told. It is common knowledge that whenever everybody is thinking the same thing and acting in the same manner, rationalizations are but an excuse for all types of madness, but even so, how strong is the relationship between gold and inflation anyway? Gold has been in a bull run throughout the 2000s, fuelled by the easy money policies of central banks of the world, while inflation has remained in a subdued range in the U.S and elsewhere ever since Paul Volker`s decisive leadership reinvigorated the American public`s confidence in the Federal Reserve`s commitment to keeping price pressures under control. The median value of year-end inflation statistics is a meager 3.2% for the past 30 years. That number is above the Federal Reserve`s target, but is not a sign of failure in our opinion, since it is skewed to the higher side by the very high numbers in the 80s.

We did a mathematical test

One can certainly make a logical case, at least at a basic level, that gold is a play against inflation, due to its limited supply, and intrinsic value in many cultures. That is indeed the main basis of the arguments of many people in the financial world. But we at forextraders.com decided to do away with baseless speculation for a moment, and to subject the claims of goldbugs to a test through mathematical methods. By checking the cross-correlation between oil, gold, and inflation over a 30 year period, beginning in 1980, and reaching to our day, we were able to reach at some surprising conclusions.

We first checked the relationship between year-end gold prices in the period of 1980-2009, and annual CPI inflation figures in the U.S by introducing a lag of seven years at a confidence interval of 95%. As you can see in the above graph, there is barely a perceptible relationship between year-on-year CPI and gold prices. Correlation never rises above 0.2 which is well below the red lines indicating the lack of a statistically significant relationship between the two measured quantities.

Indications that the gold price is a bubble

The result must be surprising to many of our readers, but for us, it is not. Gold is just as much of a speculative instrument, as stocks, commodities, and their derivatives are, and there is hardly a single reason to justify the blind trust shown by many people in the shine of the metal. Is it possible that gold can be overpriced? Very few would reject that. Is it possible that it can be overpriced extremely? This, in fact, did happen in the past, and there is every indication that we are in another period of a frothy, bubbly gold bubble.

All that is not to say that gold will not rise. There is a significant possibility that gold prices will bubble up to a few thousand dollars in the next few years, but that will not be result of prudent investors hedging against inflation in the way that we are told that they are doing. It is the old-fashioned, vigorous kind of speculative excess that is keeping gold at its present levels. There is no difference between the forces that drove the DOW above 15,000, and the dynamics that are now taking gold to beyond $1,000.

A similar, but perhaps more interesting picture exists in the case of oil and the CPI. It is common wisdom that higher oil prices lead to higher inflation, but as far as the numbers are concerned, there is no clear relationship. Although the result seems surprising, it is not that surprising if you consider the enormous swings in the oil market over the past two-three years, and imagine what would have happened if they had an equally powerful reflection on the overall inflation that we experience. Clearly, competition in the U.S. is a far more powerful deteminant in determining price pressures than even the wildest swings in the oil market provided, of course, that remain of short duration.

The one weakness of these results is that the CPI figures are not cumulative. If we had plugged in a chain-price type index, the cross-correlation comes at slightly above 0.4, which is still not very significant. Still, we do believe that they demonstrate something: that some commodities are racing to the skies at the moment is by no means an indication that we are going to face hyperinflation anytime soon. All the signs are pointing to deflation, and not inflation, and if we are proven right, this may well be one of the greatest economic surprises of our time.

Read also how gold affects different currencies.

You can also read how inflation measures impact the forex market.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.

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