With inflation raging, financial commentators suggesting that gold is no longer a valid inflation hedge must have very short memories.
Indeed, the price of gold may be volatile in the short term and unable to keep pace with rising rates during this period of inflation. However, the data over the long term suggests that gold is a perfect ‘hedge’ against inflation.
Gold price vs inflation
The term “inflation” is commonly used to refer to the rise in prices measured by the Consumer Price Index (CPI).
However, this definition is not technically correct.
The economic definition of “inflation” is the rate of increase in the money supply over and above the rate of increase in economic wealth output.
As Milton Friedman famously said:
“Inflation is always and everywhere a monetary phenomenon…it can only be produced by a more rapid increase in the quantity of money than in output.”
Price inflation is thus caused by inflation of the money supply.
We’ve seen plenty of money creation or “quantitative easing” in recent history. The central banks have relied on the printing presses since the Crisis of 2008. They switched them on again through the pandemic. They did this to put cash in people’s pockets and to bail governments out as their tax bases collapsed.
This always leads, eventually, to inflation and the concept behind it is pretty simple. When the money supply increases faster than wealth output, there are more currency units relative to the supply of “wealth units”.
Wealth units represent the number of goods and services that an economic system can supply. Quantitative easing leads to more money “chasing” a relatively lesser amount of goods and services.
When this happens, the law of supply and demand applies. This dictates that the price of the wealth units will increase.
Let’s take a look at the data. The chart below shows the price of gold vs. the CPI and the M2 money supply going back to 1990):
How does gold hedge against inflation?
What does the chart above tell us about the last 33 years? It shows us that investing in gold provides a hedge against both price inflation and money supply inflation.
Gold underperformed both inflation metrics from 1996-2001, but this period of time was the final culmination of a bear market in gold that began in 1980. Between 2001 and late 2011, gold outperformed as an inflation hedge, more than compensating for the previous period of underperformance. Since 2016, gold has performed spectacularly as an inflation hedge.
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.”
In other words, because of its commodity price volatility attribute, gold might not be a perfect hedge against inflation in the short run, but works well as a long-term hedge against price inflation caused by the devaluation of fiat currencies from money printing.
The chart above, prepared by the World Gold Council, shows the compounded annual growth rate (CAGR) of gold, the U.S. M2 money supply and the U.S. CPI going back to 1971, where all data is indexed to 100 in Q1 1971.
Again, while there was a brief period in the late 1990s to 2001 in which the price of gold underperformed inflation, over the entire data series, gold outperformed both price and monetary inflation.
Why is gold an inflation hedge?
That’s a question for which there is not a scientifically proven explanation beyond the actual statistical data observations.
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. Both were shown to increase approximately 3% annually (“smoothed out” over decades and centuries).
Issuing currency in varying units of denomination enables the use of gold as a reserve asset against the issuance of that currency and enables the fungibility of gold – constraining the growth in the supply of currency (money) to the amount of gold that is produced. This can then 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 served as an inflation hedge but also outperformed the rate of inflation.
Does gold beat inflation?
With gold being an ideal way to offset rising inflation rates and provide stability to a portfolio, investing in the right gold products is also an essential consideration before looking to hedge against inflation.
Kinesis offers instant access to physical bullion through Kinesis gold (KAU) and silver (KAG), digital assets backed by gold and silver bullion. The platform also offers everyday utility to precious metals through the Kinesis Virtual card and enables you to use your physical gold and silver account as currency.
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 views expressed in this article are those held by Dave Kranzler and not Kinesis.