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Is Gold an Adequate Hedge Against Inflation?

How often have you heard the old maxim that gold is a great hedge against inflation? Most investors have heard that saying hundreds of times from hundreds of sources. But is gold really an inflation hedge? How can we know? That's the subject of this week's post.

Definitions
To find out if gold is a good inflation hedge, we must first decide on some definitions. First, by gold, let's use the price of an ounce of the bullion. We have data back to 1971.

Second, we will use CPI as our measure of inflation. We are well aware of the problems associated with using the CPI, and you can read more about that here, but it will still accurately capture the direction of inflation, even if its level is suspect.

How Will We Know?
There are two ways to find out if gold is an exemplary hedge against inflation. First, we will want to see the price of gold increase if inflation does. This will provide our empirical evidence. Further, we can run a correlation test on the two sets of data, and if gold is indeed a good hedge against inflation, we would expect the correlation to be high - say .70 or greater. Correlation measures the degree of association between two time series ranging from -1 to 1. A very high degree of positive association would be evidenced by a correlation near 1. A very high degree of inverse association is evidenced by readings close to -1.

The second way we can find out if gold is a good hedge against inflation is to examine the theory. Why should gold be a good hedge? Why should its price appreciate as inflation increases? If we can't come up with an answer here, all the empirical evidence in the world must be viewed with suspicion.

In other words, to say with any degree of confidence that gold is a legitimate hedge against inflation, we must have our theory laid out in comprehensible terms and then we must make sure history has agreed with our theory.

The Empirical Test
First, let's eyeball the relationship between gold and the CPI. This will be informative:

This really does not bode well for those expecting a strong relationship between the two. Over the span of 19 years, gold lost 38% while prices were up 114%. Gold in our portfolios would not have helped out much over these two decades. Note that the price of goods (the CPI) is always going up; gold isn't.

But, just for the sake of completeness, let's find out what the correlation was between gold and the CPI from 1971 through 2007. As it turns out, Excel can easily compute this for us, and the correlation is .61. Above, we wrote that a strong correlation would be between .70 and 1.00. So the .61 is a positive correlation, which we would expect, but it is not very strong. Perhaps a great theory can bail us out.

What About the Theory?
Alright, so we've established that empirically, there is a lack of strong evidence for gold being a great hedge against inflation. But, should we expect a stronger relationship than what we found? After all, there are literally millions of forces impacting the price of gold. Maybe those forces were concealing the true nature of gold's relationship with inflation.

There is only one reason why gold should appreciate as prices do - gold itself is a commodity. Prices of finished goods move up because, among other things, the prices of the commodities used to produce these finished goods are going up. This seems logical enough, but clearly is not the case. Why not?

For the answer, we would direct you to the most comprehensive study of gold that we are aware of - Roy W. Jastram's The Golden Constant. Jastram studied gold going back to 1560 and found that, contrary to theory, gold behaves independently of all other commodities, which in fact, follow gold. That's why there is a weak positive correlation - gold moves and then other commodities follow. Gold precedes inflation and it precedes disinflation. It even precedes deflation, where we actually see a negative correlation between price levels and gold.

Conclusion
The bottom line is that neither theory nor history supports the old maxim that gold is a suitable hedge against inflation. Why is this important? Because many people feel that they ought to own at least some gold to hedge against prices which seem to consistently rise. The fact is that gold, like every other asset class, goes through periods of appreciation and periods of depreciation.

In fact, Jastram found that gold appreciates more in deflationary, rather than inflationary, regimes. In other words, gold holds its value rather well. This is a very important conclusion for those would-be gold bugs.

Since gold has very little industrial utility and comparatively low global demand for esthetic uses like jewelry, the source of so much demand for gold is somewhat perplexing. How do we explain a secular bull market in gold?

Primarily, gold is what you want when all heck breaks loose. You want gold to serve as your passport, currency and protection. State (fiat) money will not do this in extreme times. This explains gold's popularity in times of crisis and panic.

Alan Greenspan himself, in testimony delivered to Congress in 1999, states that

"…gold still represents the ultimate form of payment in the world. It's interesting that Germany could buy materials during the war only with gold. In extremis fiat money is accepted by nobody and gold is always accepted and is the ultimate means of payment."

Let that last sentence sink in while you're reflecting on the source.

One final thought on why gold has secular bull markets - supply is more important than demand. Gold has a limited supply, much like oil. However, oil is consumed. Gold is largely produced for accumulation and not consumption. This gives gold some unique characteristics, primary among them is that the decision to produce gold (or, rather, conduct mining operations) is largely undertaken only when there is a significant assurance that demand is growing and will continue to do so. An expectation of global unrest would be an excellent example.