While the price of gold is subjected to short-term volatility swings, an examination of the data over a longer period of time suggests that gold is not only correlated with inflation, it acts as a hedge against inflation. Silver also performs well as an inflation hedge.
What is inflation?
The term “inflation” is commonly used in reference to rising prices as measured by the Consumer Price Index. However, this is not technically correct. The economic definition of “inflation” is the rate of increase in the money supply in excess of the rate of increase in economic wealth output.
As Milton Friedman famously said, “inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
This quote describes central bank monetary policy in relation to wealth output since quantitative easing AKA “money printing” commenced in late 2008.
Price inflation is thus caused by inflation of the money supply. The concept is pretty simple: when the money supply increases at a rate in excess of wealth output, there are more currency units relative to the supply of “wealth units,” where wealth units represent the number of goods and services supplied by an economic system.
This results in more money “chasing” a relatively lesser amount of goods and services. When this occurs the law of supply and demand dictates that the price of the wealth units will rise.
How does inflation affect gold & silver prices?
Let’s take a look at the data. The chart below shows the prices of gold and silver vs. the CPI 1990 (I would have taken the data back to 1971 but the Federal Reserve has removed the price of gold from its historical database ((the St. Louis Fed’s FRED database)):
The chart above shows that, over the last 32+ years, gold has been well correlated with the CPI index, and thus the rate of inflation. Between 1995 and 2001, during the last six years of the precious metals bull market that lasted from 1980 to late 2000, gold and silver underperformed the CPI index.
But between 2001 and mid-2011, both metals handily outperformed the CPI. Over the entire period, the price of gold and silver rose in lock-step with inflation. Though silver somewhat underperformed inflation over the last 32 years, I believe that silver will play “catch up” with both gold and inflation, making it attractive as both an inflation hedge and a total rate of return investment.
Further supporting this finding, Reuters published a study by the World Gold Council earlier this year which looked at gold as a hedge against inflation. The findings support my conclusion above: “Gold is a proven long-term hedge against inflation but its performance in the short term is less convincing.”
Why is gold considered an inflation-proof investment?
In other words, because of its commodity price volatility attribute, gold might not be a perfect hedge against inflation in the short run, but it works well as a long-term hedge against price inflation caused by the devaluation of fiat currencies from money printing.
The chart, sourced from December 1, 2022, shows gold vs the CPI index from 1971 to mid-2022:
1971 is a significant benchmark date because that is when the world officially came off the gold standard when the U.S. government removed the Bretton Woods Agreement, which established the terms of convertibility of sovereign-held dollars into gold as a means of establishing the dollar as the world’s reserve currency. The price of gold, which had been pegged at $35, was allowed to “float” as a market-priced asset.
Why does inflation increase the gold price?
Why does gold hedge against inflation? That’s a question for which there is no scientifically proven explanation beyond statistical observations, like the chart above, which confirms that the gold price and inflation are highly positively correlated over long periods of time.
The principles of economics can be used to explain the correlation between gold and inflation. Over extremely long periods of time – as in centuries – the increase in the supply of gold annually roughly is equal to the long-term growth in global economic output.
Over a time period of many centuries, both the supply of gold and the rate of economic output increased at approximately 3% annually. Issuing currency in varying units of denomination enables the use of gold as a reserve asset against the issuance of that currency by creating “fungibility” of the central bank gold that backs the currency issued by that bank.
Constraining the growth in the supply of currency to the amount of gold that is produced and can be used to back currency, limits the ability of central banks and governments to “oversupply” currency.
However, since 1971, when the gold-backing of the U.S. dollar as the global reserve currency was completely removed, there have not been any real constraints on currency creation.
Since 1971, periods of price inflation have become problematic and it is during those periods when the price of gold not only has served as an inflation hedge but also has outperformed the rate of inflation.
Because the rate of return on gold has lagged behind the rate of inflation over the last couple of years, it suggests that investing in gold now offers an opportunity to use gold, and silver, as both an inflation hedge and a total rate of return investment asset.
How can you invest in gold & silver?
While I highly recommend investing in physical bullion – like sovereign-minted bullion coins and bars – and keeping the bullion in your physical possession, there are digital platforms like Kinesis that offer not only a good way to invest in physical gold and silver but also the ability to use those funds for consumption.
Kinesis gold and silver investment accounts are backed by physical gold and silver along with the Kinesis Virtual Card which enables you to use your physical gold/silver account as currency.
Alternatively, you can also take delivery and possession of your physical metal. Since I hold plenty of physical gold and silver, I use my Kinesis account as a savings account that 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.
This publication is for informational purposes only and is not intended to be a solicitation, offering or recommendation of any security, commodity, derivative, investment management service or advisory service and is not commodity trading advice. This publication does not intend to provide investment, tax or legal advice on either a general or specific basis. The opinions expressed in this article, do not purport to reflect the official policy or position of Kinesis.
