The Federal Reserve and the so-called experts were wrong: inflation has not been a transitory phenomenon.
Though the rate of inflation cooled in mid-2023, resulting from the U.S. government’s drainage of its Strategic Petroleum Reserve to push down the price of oil and gasoline, the most recent data suggests something else entirely. Not only has high price inflation been “sticky”, with respect to food and housing costs, but it appears that the rate of inflation is rising again, particularly for consumer necessities like energy and groceries.
This article looks at how gold and silver perform as an inflation hedge, at a time when financial mainstream media has been avidly disseminating articles that suggest gold is no longer a hedge against inflation.
While the price of gold is subject to short-term swings, the long-term view suggests that gold and silver are, in fact, effective hedges against inflation.
How does inflation affect gold prices?
Price inflation is caused when the increase in the money supply exceeds the increase in wealth output of an economic system. Quite simply, when there’s a greater relative amount of monetary units available to purchase wealth output units.
By the law of supply and demand, the price of the wealth output units increases. However, it’s not so much that the price rises, but rather, the value of each monetary unit created declines. Therefore, it takes more dollars to buy each unit’s products.
This phenomenon applies equally to gold and silver. It’s not so much that the value – or purchasing power – of gold and silver are rising, that increased monetary supply is devaluing each currency unit created, so it takes more of the respective currency to buy an ounce of gold or silver.
As such, gold and silver used as currency retain their purchasing power and thereby function as a wealth hedge. Over longer periods of time both gold and silver have proved to be effective hedges against currency devaluation (aka price inflation).
Gold’s historical track record as an inflation hedge
The long-term track record of gold versus inflation requires the right measure of price inflation. An overwhelming amount of research has shown that government-based inflation measures, like the Consumer Price Index, are invalid measures of the true rate of price inflation. A better measure involves looking at changes in a country’s money supply. This is a better proxy for the relative value of the country’s currency.
Reports have shown that gold has an inconsistent correlation with the CPI, and therefore an inconsistent hedge against inflation – as measured by the government. However, academic research has concluded that to measure true price inflation resulting from dollar devaluation, a broader measure of inflation is required.
In addition, the rise in the money supply, as measured by the U.S. M2 could be considered a valid measure of price inflation – or rather, the degree to which rising money supply devalues the given currency. The conclusion was that there is a strong linkage between the price of gold and changes in the money supply.
How does inflation affect silver prices?
Silver is an effective inflation hedge because it can also be used as a monetary metal. In addition, silver functions as an industrial metal, which makes industrial demand one component of silver’s short-term price determination. Industrial demand for silver ebbs and flows with the economy. Due to this, the silver price is more volatile than gold.
Gold’s and silver’s track record as an inflation hedge
The chart below shows the performance of both gold and silver as an inflation hedge from 1990 to the present:
Within the 23-year time period, gold and both underperformed and outperformed the inflation rate. However, over the entire time period, both gold and silver proved themselves as an effective hedge against price inflation. Silver has underperformed versus gold and inflation since 2013.
I would argue that it is because the U.S. economy has been sluggish and in and out of periods of economic contraction (though not long enough for a “technical recession”). This has affected the industrial demand component of silver’s market value.
In the next cyclical bull cycle for the precious metals, I expect silver to “catch up” to and then outperform both gold and price inflation.
What are the best inflation hedges?
During periods of inflation, finding ways to preserve the purchasing power of your earnings and wealth becomes desirable. A common investment used as a hedge against inflation is TIPS or Treasury Inflation Protection Securities. These are bonds issued by the United States Treasury with a rate of return that is indexed to the Consumer Price Index. Notwithstanding, the CPI is a highly flawed index inflation when the TIP bond matures, since you receive dollars – the same ones devalued by Federal Reserve money printing.
Investing in a commodities fund is probably a more effective way to hedge your wealth from the purchasing power devaluation effect of inflation, aka fiat currency devaluation. Since the broad range of commodities is used to produce non-discretionary consumption items, the cost to produce commodities can be largely passed on from the producer to the end user. Due to this dynamic, the value of commodities for the most part is correlated with the cost to produce them. Thus, in an inflationary environment, investing in commodities should adequately hedge against inflation.
Real estate traditionally has been a good hedge against price inflation. But since World War II, and particularly over the last 50 years when the world went entirely off the gold standard, real estate has been transformed into a financial asset – think of it like a bond. This is because modern finance has enabled the widespread and prolific use of debt to buy real estate. The value of real estate is driven by interest rates and the amount of debt banks are willing to extend for buyers to purchase real estate. As such, the value of most real estate fluctuates with interest rates, like a bond. In my opinion, real estate is no longer such a good hedge against inflation.
Given the empirical data, gold and silver are categorically the most effective ways to protect your income and wealth against inflation over long periods of time. The rate of increase in the M2 supply of money since 2011 has outpaced the rise in the price of gold and silver. This makes gold and silver undervalued relative to the supply of dollars, as priced in dollars.
The price of gold is hitting all-time highs against several other currencies like the yuan, Saudi royal or the Euro. I expect that gold will hit an all-time price in dollars, but also that the silver price will “catch up” to the performance of gold and hit an all-time high. This makes gold and silver both effective inflation hedges and alpha-generating investments.
One easy and convenient way in which to invest and trade precious metals is by opening a Kinesis account. Investors can own allocated, insured gold and silver with their account and even take delivery of the physical metal – at any time. Since I hold plenty of physical gold and silver, I use my Kinesis account as a savings account for which I’m highly confident will track inflation and preserve the wealth value of the account.
Dave Kranzler is a hedge fund manager, precious metals analyst and author. After years of trading expertise build-up on Wall Street, Dave now co-manages a Denver-based, precious metals and mining stock investment fund.
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