Inflation And Gold: Part 1

See the original article at http://bidhitter.com/blog/inflation-and-gold-part-1/ Much has been said over the past few years with the respect to inflation and gold as the thought is that gold is a good hedge against inflation. This is partially due to the thought that the price of gold stays relatively constant and the valuation of currencies merely fluctuate around it. As a result, many people, funds, and countries, are looking towards gold as a hedge against inflation. But is it true? Since March 9th 2009 when the Federal Reserve announced it was expanding its quantitative easing program, the S&P 500 rallied slightly over 100% at the expense of the US Dollar. During the same period of time we saw gold also roughly double. At first glance the view that inflation and gold are highly correlated seem valid. In fact they are perceived to be so highly correlated that people are having flash backs to the 1970s when interest rates were upwards of 20%. Yet, interest rates among the largest nations in the world are at virtually all time lows. What gives?

Inflation And Gold: The Gold Standard

Prior to 1971, the United States was on the gold standard. What this meant was that the value of the US Dollar was pegged to the value of gold. Valuations of currency are a direct result of the supply of currency which was adjusted based on the price of gold. Guess what, so are interest rates. What I am leading to here is that the relationship between inflation and gold was disastrous to GDP and Employment while on the gold standard. How come? Very simple.
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Way back when during periods of deflation, all asset classes declined in value. The same holds true today. Thus, back when we were on the gold standard, periods of economic contraction and rising unemployment were not met with a reduction of rates and an increase in money supply in effort to spur investment. Instead what happened was that as the price of gold fell, the value of the dollar also decreased because of the peg. However, the money supply stayed inflated on the way down. This caused an INCREASE in interest rates to reduce money supply during periods of deflation which raised the cost of capital and the cost of investment due to the physical quantity of dollars in circulation needing to contract in order to keep the value of the dollar pegged to gold. Such increases in rates lead the supply of money in the economy to contract when we needed it to expand the most. This is why if you look at GNP back before the Federal Reserve was instituted we didnt have recessions, but outright depressions every 5-8 years on average. We literally wound up having deflationary spirals on a regular basis. Thus gold as the backing of currency was inherently deflationary and detrimental to economic growth let alone recovery from depressions. This is partially why we saw FDR defacto try to get off the gold standard during the Great Depression.

Inflation and Gold: Modern Day

Often we hear people pointing to gold as a hedge against inflation due to the appreciation in price relative to actual inflation during the 1970s. Certainly, gold did rise in price during the 70s it rose a lot. However as Kindelberger put it Gold was going up because gold was going up. What he was describing was a mania before the panic and subsequent crash. This day and age, people seem to forget one important aspect of the deflationary quality of gold that, while no longer on the gold standard, we cannot get away from. At least not those of us in the United States. That is, the relationship between inflation and gold is mathematically inverse. How?
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Simple Gold is priced in US Dollars. This means that as the demand for gold increases, the demand for dollars also increases. Not only domestically but also abroad. So if you refer back to economics 101 youll remember that as the Qd USD rises so does P. And what does a rising dollar spell? Deflation. So how is it that if the bid for gold is inherently deflationary due to an increase in demand for dollars that we had such a huge run up in gold and inflation during the 70s? First we have to compare like versus like as Milton Friedman always said. The size of the market for gold back in the 70s was much smaller than the size of the market for gold is today. So the relative bid for dollars was much smaller than it is now. Electronic trading and further advancements in technology have greatly reduced the cost to participate in such markets in addition to their accessibility increased via ETS and other such investment vehicles. Currently as of tonight (12/12/2011) the total value of the GLD ETF (which is traded heavily on our Virtual Prop Desk) is $71,168,045,704.04. Thats a 71billion dollar bid for dollars to buy gold that didnt exist back in the 70s. Furthermore this doesnt include the bid for dollars in the futures markets, physical etc. It winds up being a lot of dollars that as being bid for in order to purchase gold. This also doesnt include the foreign bid for dollars to purchase gold either. Second, all things are relative meaning that while the market for gold was smaller in the 1970s than it is now, the demand for dollars was still elevated relative to demand for dollars when gold was cheaper. As such, we have to look at what inflation was versus what it could have been if the bid for dollars wasnt as large. Had gold not risen in the 70s, inflation would have actually been higher. This is why the price of gold has put a thorn in the side of the Federal Reserve during the recent QE programs. The more they ease, the more of that money has gone back into the US dollar to buy gold effectively nullifying

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(at minimum retarding) the impact of QE programs on the economy. Simply put their efforts to create inflation hasnt actually worked. Inflation and Gold Part 2 will begin to take a look at various different statistical measurements to quantify and visual see the relationship between inflation and gold. You will be shocked by what you see and by what is on the horizon for the price of gold!
Further reading: Part 1 | Part 2 | Part 3 | Part 4

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