For millennia, people have turned to gold as an inflation hedge. I have shown below that gold price movements are strongly correlated to the overall price level (CPI). It has been said that the price of gold has no relation to the overall cost of living, often measured by the CPI, the consumer price index (see this article by Dr. Paul Krugman). This idea is often tied in with the notion that gold is in a speculative bubble.
Instinctively I have known this is wrong, but I finally have data to back this up.
The crux of my piece is that gold price is not in a bubble like some people say it is.This seems to hold true for both short-term and long-term movements.
Note that in the trend charts below, I cropped the data to start on Jan. 1, 1971, when the redemption link between gold and the dollar was severed.
I. Gold and Inflation
Here is a comparison of the change in the gold price with the CPI. Both are set to percentage change from one year ago.
Note that the scale for gold is magnified by 10 compared to the CPI. While the correlation is nowhere near perfect, this strongly indicates that gold movements are largely based on inflation.
This chart was made using the data tools available at the St. Louis Federal Reserve website. Both CPI and gold numbers are based on monthly averages for uniformity.
b. Ten Year Movements
This chart from macrotrends.org shows a similar phenomenon, however it is based on 10 year changes and not 1 year changes.
While the recent divergence might cause some to think gold is in a speculative bubble, this has more to do with the weakening of the dollar against other currencies and negative real interest rates, shown below.
Note that 0% is not at the same spot on both lines.
In many ways, gold trades more like a currency than a commodity (see here and here), so it is not surprising to see an inverse relationship between the gold price (in dollars) and the overall strength of the dollar. Since around 2000, the dollar has fallen dramatically against other currencies, thus exacerbating gold’s recent bull run.
III. Gold and Interest rates
Since gold is not an investment per se (it yields no interest, dividends, or rental income), people will not put much money into gold if real (inflation-adjusted) interest rates are high.
This is demonstrated empirically by the chart on the left.
Since the collapse of the NASDAQ bubble around the turn of the millennium, interest rates have been unusually low by historical standards (see graph below at right), which has been good for gold.
As the Federal Funds Rate (the basis of all other interest rates) will be kept around 0% through mid 2015, and annual inflation hovering around 2%, this should not put any immediate downward pressure on gold in the foreseeable future.
As can be seen on the right, for years now forecasters have been predicting gold prices to plunge. The only way I could see this happening is from some combination of the following: deflation and/or strongly positive interest rates and the dollar gaining strength against other currencies.
No official at the Federal Reserve has called for any of these, and the chance that these things happen for any prolonged period against the Fed’s wishes seems quite slim.