How Gold Lost Its Inflation Luster

Gold’s price does not correlate with inflation expectations either. Source: FRED

Nor does gold’s price correlate with inflation expectations, as shown above. Here too, gold’s price would rise and fall along with the market’s outlook if it were an effective hedge. However, no relationship exists.

This is all quite puzzling on the surface. How can gold be disconnected from inflation? Why is our modern experience so different than the historical one? The reason, in my opinion, is definition changes—for both inflation .

Throughout most of history, monetary standards were defined. Precious metal regimes are the most famous examples, though there were others. At one time, $20.67 U.S. dollars was defined as an ounce of gold; the Roman denarius was a coin that contained 4.5 grams of silver. While people most commonly used currencies—the medium of exchange—they were actually trading in terms of those precious metals which were the (implicit) standards for measuring value.

Thus, governments debased currencies (and created inflation) by reducing their precious metal content (or convertibility). While monetary standards changed (i.e., the amount of metal content in each currency unit), the metals’ values, of course, did not. Thus, prices increased in currency terms. However, they remained (relatively) constant in precious metal ones. Hence, direct gold ownership protected against inflations.

Today, however, we have fiat money regimes. There are no monetary standards, by definition. A dollar has no codified value. Rather, it’s worth whatever it fetches in trade. Hence, inflation, in the classical sense, is impossible. There simply is no monetary standard to change! Using the change in CPI (or some equivalent method) as an inflation-gauge is a (flawed) workaround.

Trade requires a common language for value, just like construction requires one for length. Gold (or rather its weight) played this role historically. Today though, it does not.

Absent its special role, gold’s just another “hard asset,” like real estate, corn, or art. While money printing by sovereigns might increase gold’s market price, there’s no assurance that it must. If the Federal Reserve conjures more dollars, those new dollars (first) impact prices where they are spent (or by those who react to it). Gold’s price may or may not change. This differs from a gold standard where its price must—by definition—change in lockstep!

"The first change [in price] occurs at the point where the additional money is introduced into or taken out of the economy and is expressed in an increased or decreased demand for the goods and services desired by the persons directly affected by the change in the quantity of money." - Clark Warburton, ‘The Misplaced Emphasis in Contemporary Business-Fluctuation Theory‘ in American Economic Association Readings in Monetary Theory

Let’s illustrate this point with a hypothetical example. Say $10 dollars was defined as an ounce of gold (i.e., a gold monetary standard) and you possessed 10,000 ounces. You’d have $100,000 of purchasing power (10,000 ounces x $10). Now, say we debased the monetary standard such that $20 dollars now equaled an ounce of gold. Consumer prices would inflate by a factor of 2 in terms of gold. Those holding currency would lose half their purchasing power. Not you, though. Your 10,000 ounces of gold are now worth $200,000 and is the perfect hedge!

However, things work differently in fiat currency regimes. There is no explicit monetary standard. Thus, in order to devalue the dollar by half (as we did above) we’d need to double the quantity of dollars in circulation, all else equal. According to theory, this increase in the money supply (or rather currency supply, as I see it ) should elicit an equal response in consumer prices. They should (theoretically) double; gold’s too.

However, this won’t automatically happen as it did in the gold standard scenario. There, gold must double in dollar terms because of how we defined dollars. In the fiat case, however, gold’s price might increase; but it might not.

Nor would it necessarily do so immediately or proportionately to the currency supply increase. It all depends on people’s spending patterns. Gold’s price rises only if and when people bid it up, like all other goods and services. Thus, the hedge is imperfect at best, and potentially nonexistent, as the previously presented data suggests.

Gold may no longer hedge inflation as effectively as under the gold standard, but it still might have investment merit. For example, one Artemis Capital Management study found that “gold has outperformed the stock market on a price appreciation basis over the past 48 years since Nixon de-linked U.S. dollar-based convertibility on August 5th, 1971.” Their ideal portfolio contains an allocation to the “barbarous metal” due to its large and uncorrelated returns.