In the last couple of years, gold prices have had an astonishing run, rising on the prospect of potential inflation to come. Most of the rise has occurred on the back of the quantitative easing policies pursued by the US Federal Reserve. Gold demand is primarily driven by a safe haven factor. Investors buy gold when they are worried about the economy, and specifically worried that fiat currencies will lose value due to excessive inflation.
It seems to be commonly accepted in markets that higher gold prices are an indication that future inflation will be high. Now we donít know whether inflation will be high in the years ahead. But we can look at the past. We can see whether previously higher gold prices led to higher inflation. So we decide to put this inflation theory to the test on previous data. We look at annual inflation rates in dollars (US inflation), and the average annual price of gold in dollars from 1967-2010. Here is what we find.
We focus specifically on instances when gold prices went up a lot, and see if this led to higher inflation in the following year. From 1971-1973, gold prices increased by over 100%. Inflation in 1974 was higher than the previous three years. In 1980, gold prices increased by 100% again. However, inflation in 1981 fell from the previous year, and continued to fall in the following year.
After 1980, gold prices fell considerably over the following years and did not reach its 1980 level until 2006. During that time period inflation rates were low, generally staying well below 5%. This does seem to suggest that falling gold prices are associated with lower inflation.
The next big gold run started in 2005 and has continued until today. From 2005-2010, gold prices have increased by an astonishing 180%! However, the average annual inflation rate during this period has only been around 2.3%, which is very low by historical standards and certainly would not justify the current price increases in gold.
The overall evidence appears to be quite mixed. There does appear to be a positive relationship between gold price changes and inflation rates, however it is often quite weak. The weakness has been especially present since 2005, when gold prices have been soaring, yet inflation rates remain low.
One thing that is very clear from the data is that the gold is much more volatile than inflation. For example, the highest annual change in gold prices is around 100%, and the lowest annual change in gold prices is around -25%. This indicates the high volatility of gold. When we examine inflation rates, the highest annual inflation rate is around 13%, and the lowest is around 0%. Clearly inflation is much less volatile than gold.
Given all this information, it is certainly not clear whether todayís high gold prices will mean that future inflation will be higher. One thing that is clear is that inflation will probably not skyrocket even if gold prices increase a lot. History has shown us that even when gold prices go up a lot, inflation only goes up a little.
Disclosure: I do not hold the currency/commodity viewed/opined in this column
Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!