The Link Between Money Supply, Gold Prices, and Inflation

The World Gold Council just released a new report which analyzes the link between the global money supply and gold and inflation. The analysis is particularly relevant today as both gold prices and the money supply have surged during the global financial crisis.

What the analysis reveals is that:

• A 1% change in US money supply growth six months prior, in turn has an impact of 0.9% in the price of gold, on average. A 1% change in money supply in India and Europe six months prior, affects the price of gold by 0.7% and 0.5%, respectively.
• An increase in the price of gold can be interpreted as a signal by the market that velocity of money is poised to increase in the future and, consequently, be a signal of future inflation.

Here's a graph of gold prices over the last ten years:

Here is another graph comparing the S&P 500 to gold and oil prices.

What really interesting about this correlation is that there is a six month lag between an increase in money supply and a rise in gold prices. The question is whether the inverse is true. Will a 1% decline in money supply lead to a .9% decline in gold?

The other interesting conclusion is that a rise in gold prices is a signal for future inflation. As the chart above shows, we've seen an incredible increase in the price of gold over the last decade, even as the inflation rate has trended down. If this correlation holds, then red lights are now flashing a warning about future inflation.