What is Gold? Reader Finds Answer|
January 23, 2014
Several weeks ago, Numismatic News editor Dave Harper asked the question that is the title of this article. That question immediately brought to mind all the standard answers. Gold is a dense, non-tarnishing, yellow metal that is used for jewelry and industrial applications. It formerly was used as money and is now used as an inflation hedge. These rote answers led me, however, to my own question. Is gold really an inflation hedge?
To answer this question, I did a little research. Using the Federal Reserve of St. Louis’ website, I downloaded two data series: the Consumer Price Index (CPI) for all urban consumers provided by the U.S. Bureau of Labor Statistics, and the London morning price fix for gold provided by the London Bullion Market Association. My goal was to put these two sets of data on a common basis and then plot them on the same chart. My thinking was that if gold were truly an inflation hedge, the two curves would look similar.
Since the CPI data are reported monthly, I had the daily gold prices converted to monthly averages. Then, I normalized each set of data, which simply means that all data in a set were divided by the initial value of the set. Thus, on day one of the reporting period, both the CPI and gold price are valued at 1. If gold were a perfect inflation hedge, its price would increase or decrease in lockstep with the CPI. Before displaying what I found, let me note that the period covered runs from Jan. 1, 1975, when Americans could once again legally own gold, until the present. The performances of both quantities over that time period are displayed in the first chart.
Looking at the two curves, it was unclear to me that gold is a proxy for the CPI. In fact, the curves do not even look highly correlated. While the CPI is almost unrelentingly upward, there are many times when the price of gold is falling. In fact, there are only four bumps where the performance of gold exceeds the CPI.
Due mostly to the quadrupling of oil prices in the mid-1970s, consumer prices essentially doubled between 1975 and 1983. The price of gold followed suit, and with the help of the Hunt brothers and others, outperformed inflation during this period. The only other periods where gold outperformed inflation were around the time of the 1987 stock market crash and following the financial turmoil of 2007-2008. During the long bull market in stocks, which ran essentially from 1982 to 2000, gold did not keep up with inflation.
Given the above information, I believe that I can now answer the question, “What is gold?” Gold is a rare commodity that typically trades at either a “panic premium” or at a “complacency discount.” In unsettled times – stock market crashes, inflationary spirals, or general financial uncertainty – gold trades at a premium to its inflation-adjusted price. During good times for paper assets, non-earning gold trades at a discount to inflation. These premiums and discounts can be very sizable. In 2011, gold’s premium compared to inflation exceeded 100 percent. On the other hand, gold’s discount to inflation was approximately 50 percent in the year 2000. I believe this paragraph answers David’s question. However, I have yet to answer my own question, “Is gold really an inflation hedge?”
To answer my question, I am going to do something that is really not justified mathematically. I am going to force the data in the gold price data set into a linear model. I know that the line formed will not have the predictive power of the CPI curve, but its placement and shape should give some clue as to whether gold is a good inflation hedge. If the forced trend line is significantly offset from the CPI curve, or if it is flat or downward sloping as opposed to the upward sloping CPI curve, my confidence in gold as an inflation hedge would weaken. The result of this mathematical sleight of hand is shown in the second graph.
Like I said, the trend line for gold has no predictive power, but does seem to indicate that over long periods of time, gold is a good hedge against inflation. The curve with predictive power, however, is the CPI curve. If gold is purely an inflation hedge, then it should over time revert to its mean intrinsic value. This means that it should drop to the CPI curve, which if it occurred today would price god at a tad under $800 per ounce. The only things that would make this reversion to mean not happen would be a permanent shift in demand for gold’s use in jewelry and industry, or a world in a perpetual state of financial crisis. Barring such occurrences, gold is simply an inflation hedge for which you will currently pay a large panic premium.
John Esposito is a hobbyist from Marlboro, Mass.
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On January 24, 2014 Lewis Burchett
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