Is Gold a Hedge Against Inflation?

Is gold really a hedge against inflation? Many assume that it is and have invested in gold as a way of protecting themselves against perceived future inflation. To understand whether gold has such inflation-fighting properties, I spoke with Jon Nadler, Senior Precious Metals Specialist at Kitco.com of Montreal. Jon has 32 years of experience focusing on precious metals.

First, he doesn't believe that gold is a good hedge for inflation. Indeed a report he sent me from the CPM Group’s “2008 Gold Yearbook” says the following:

...Using U.S. consumer price inflation as a proxy for world inflation is not a bad idea, given the large portion of world assets denominated in U.S. dollars. There is a 10% correlation between long-term U.S. CPI and gold. This probably would be unbelievable to those people who view gold as the ultimate inflation hedge.

The reality is that gold does well in protecting people's wealth from catastrophic inflation, wild bouts of extremely high inflation that tend to coincide with major political or economic dislocations. Gold does not do well in protecting wealth or buying power against the gnawing day-to-day inflation that wears down purchasing power. That 10% correlation extends back to 1971. Going prior to 1971, or 1968, when gold prices were freed, is meaningless, since gold prices were fixed by government mandate for most of the time from 1717 until 1968.

Since 2003 the correlation has been even lower, at 5%. Investors will hear talk about how gold maintains purchasing power over time. Quantitatively this is not true. Gold will play catch up after extended periods in which its purchasing power is whittled away by lower level inflation. Some people will speak about how an ounce of gold could buy the same goods or services today as in past years.

The measures they use pick one particular good or service and two points in time when the gold price was similar when measured against that product. For example, one favorite is the comment that an ounce of gold could buy a good meal for two at the River Room restaurant at London's Savoy Hotel in 1917 and again in 1980. That was true. In between those two times there were times when that same ounce of gold could buy less than one meal or a banquet for 17 people.

Nadler believes that a typical portfolio should hold between 6-10% of its assets in gold or some other precious metal. "Hold and forget it," he says, like a life insurance policy. That's because gold does seem to have some value as a lifesaver. If an economy totally collapses and inflation is running at 1,000% per year, then gold may be what you want in your pocket.

Why does gold have value as a currency? I's value as a pure commodity is much less than it's priced. Nadler said there is plenty of gold in the world so scarcity isn't an issue. While gold has many industrial purposes, the largest use for gold is in jewlelry. Jewelry is not a must-have product and the jewelry market, and the demand for gold, rises and falls with the general economy.

Nadler cites several reasons why he believes gold has value as a currency:

• It is no ones promise to pay. There is no debt or asset behind gold. It is the asset itself and its price isn't set by a central bank but rather by global markets.
• There is a liquid market. Depending on how you buy gold it is very easy to buy and sell.
• Can't go to $0. Gold does have an intrinsic value based on its use in jewelry, electronics, medicine and more. Its price can't go to $0.

The bottom line for gold appears to be the following:

1. Gold is accepted as a currency across the world. Its value is primarily derived not from its usefullness, but from its nature as the currency of last resort. Thus, a large part of its value is psychological.

2. In times of extreme economic crisis, gold is still generally accepted as a form of payment when all other currenciesfail. Thus, it is valuable in very extreme economic circumstances.

3. Its value holds up better in times of deflation as opposed to inflation. This makes sense. As an article printed on Mishs's Economic analysis Blog says: "Money is worth more in terms of other goods and services during periods of deflation. During periods of disinflation 'cash is trash.'"