Inflating a golden balloon??

Hi,

A topic LINKS has seen in the press on and off in recent months has been the issue of whether Gold makes a good hedge against inflation. This issue clearly isn't the only one turning the grey matter of investors who have inflation issues.

Where are interest rates going? Can markets absorb the large supply and what will happen to inflation outright? Will governments use inflation to reduce the real impact of the huge wave of public expenditure of the last few months? At this stage it's unclear what will happen and it is this uncertainty that continues to drive markets.

It is unlikely that we will see inflation rear its head for some time while there is spare capacity in the global economy. However, those with a longer -term view or those looking at the tail risk should now be considering suitable hedges.

The obvious hedge for inflation is gold. Or is it? It's a position that has reached almost mythical status but supporting evidence is thin on the ground. In fact, the seminal work by Roy W. Jastram (1977) presented in "The Golden Constant" suggests something very different. He analyses the purchasing power of gold in England and the US from 1560 to 1976. The key conclusions are that:

- Gold is an ineffective hedge against inflation
- Gold appreciates in operational wealth in major deflations
- Gold is an ineffective hedge against yearly commodity price increases
- Gold maintains its purchasing power over long periods of time. This is not because gold eventually moves towards commodity prices but because commodity prices move towards gold.

The use of gold as an inflation hedge seems to have its roots in the collapse of the Bretton Woods agreement in 1971. Since gold was no longer regarded as money it would act like any other commodity. However, during Jastram's period of study gold flips between being "money" and a "commodity" on numerous occasions: it isn't this distinction that drives the relationship. Gold may not be money but it certainly acts like it. Gold is produced for accumulation, whereas all other commodities are produced for consumption.

The other reason for the strength of the hedgers' convictions is simply poor inductive reasoning. Because gold has preserved its value in periods of big upheaval does not mean that it is useful as a strategy against cyclical behaviour. It is a crisis hedge rather than an inflation hedge.

Those wishing to hedge inflation will need to be a little more creative, particularly given uncertainty over what will cause it and the point of its emergence. Something we will return to in a later blog.

Regards,

Dr Mark Tomsett