Why gold may not be a great inflation hedge

Also read: Numbers had warned of sticky inflation, how did RBI miss it?

To check gold’s weakness as an inflation hedge at a given point in time, the authors also introduced a simple way to calculate the relative value of gold. They simply divided the nominal or market prices of gold with the CPI (consumer price index) inflation rates to get the ‘real-price ratio’; they started with the prices in 1975 since only in December 1974 did private ownership of the metal become legal. They then averaged these real-price ratio numbers to arrive at an average real price ratio of 3.2 (till March 2012).

If the market price of the metal is way above its average real-price ratio (which needs to be updated over time), then gold can’t offer much protection against inflation.

History of the constant

So where did the idea of gold as an inflation hedge really come from? Some trace it back to the early seventies, when the US President Richard Nixon unshackled the dollar from gold. Prices of goods went up, as did the price of gold. This might have been understood as gold staying on top of inflation. 

In 1977, professor Roy Jastram of UC Berkeley had proposed the idea of the ‘golden constant’. That is, the purchasing power of gold remains constant over a long period of time, whatever be the inflation. In other words, if you can exchange a coin of gold for an intricately carved table in 2000, then you can do the same in 2020. Then the metal would be a good inflation hedge, because it can help a person protect his/her purchasing power whatever the inflation numbers. 

For an asset to do that, its market value must move in sync with inflation. But authors of the Golden Dilemma found that, in shorter durations, gold prices rarely move that way.

They first plotted a regression line of market prices of gold as a function of CPI inflation–assuming that the market prices move with CPI inflation. The two used data from January 1975 to March 2012. On the same axes, they then plotted the actual market prices over the same period.

The actual prices were way off the regression line (Exhibit 1).  That is, in reality, market prices weren’t moving in sync with inflation.

Source: The Golden Dilemma paper; Graphics: Rajesh Chawla

They also assessed if the purchasing power or real price of gold was truly as constant as is believed. This they did by seeing the movement of real price ratios (they calculated by dividing the spot price with CPI index) from 1975 to 2011. They found that the real-prices ratios rarely were around the average of 3.2. The real-price ratios swung between a low of 1.46 in March 2001 and 8.73 in January 1980.

In 2020, when Erb, Harvey and Ritholtz Wealth Management's Tadas Viskanta wrote a paper titled Gold, the Golden Constant, Covid-19, "Massive Passives" and Deja Vu on the irrational exuberance around the asset created by Gold ETFs, they updated the average real price of gold to 3.8. 

In the 2013 paper, the authors also found that real prices of gold were volatile like any other asset. That is, they weren’t absorbing the effect of inflation like they inflation hedges are meant to. In fact, the study found that “the volatility of the real price of gold has been basically the same as the volatility of the nominal price of gold”. 

Also read: CEO paying employees in gold

Then they checked if gold could protect an investor against unexpected inflation. In the graph below, the authors showed that gold prices rarely rose with rise in unexpected inflation. Between 1975 and 2011, there was just one year in which gold prices seemed to correspond with the unexpected rise in inflation–1980.

Okay, so gold prices don’t track inflation well. But do their long-term returns, of say 10 years, track inflation efficiently?

To check this, in the 2013 paper, authors plotted 10-year annualised returns from the metal against 10-year CPI inflation rate. They found that the returns from the market price rarely followed the inflation trajectory. Annualised returns from the metal could vary between -6 and +20 but inflation varied only between +2.3 and +7.3%.

That also suggests that, even if the investor can forecast the inflation rates in the long term, he/she can’t forecast the metal’s spot or real rate of returns. It holds true vice-versa as well. If you cannot forecast one from the other, it becomes pretty difficult as an investor to make hedging decisions. The authors also observed that real gold return was negative from 1988-2005 even though inflation was very much in the positive territory. Obviously, the real returns failed to beat inflation during that period and therefore failed as an inflation hedge.

The authors also checked the returns gold would give if inflation held at various levels (such as 0%, 2%, 10% or 40%) for ten years. They calculated this for various real-price ratios (such as 0.2, 1.2, 3.2 or 12.2). At the average real-price ratio, none of the returns beat the inflation level. 

These findings were based on the idea that gold reserves are limited. That, in 2012, the world had mined three-quarters of its available supply. But, as Harvey said in an interview in 2021, the biggest disruption could come from the technology of asteroid mining. If this technology takes off, “just one of them (an asteroid) can double the supply of gold”, he said. 

This is not counting the massive supply of gold there is in the ocean floor. 

“Earlier, when the New World was discovered and supply of gold surged, it was devastating for the price of gold.

That will happen again. It is just a matter of time,” he said.