Gold is a Currency, Not an Inflation Hedge

Just read a WSJ article on Gold here. Thought that its pretty interesting. Main points:

  1. Gold is not a commodity, but is a currency.
  2. A commodity’s price is driven by inflation (e.g. silver, wheat, pork bellies). Gold’s correlation with inflation from 1978 is only 0.08.
  3. However, from 1973 onwards (when the dollar is no longer backed by gold), the correlation between month-end gold price and the Major Currencies Dollar Index (published by the Fed) is -0.45. From 1980 to today, the correlation is -0.65.
  4. When the dollar appreciates, the gold price drops, and when the dollar depreciates, the gold price increases. Gold is NOT an inflation hedge.
  5. When gold rallied from 1976 to 1980, it was because the dollar was declining, not because of the high inflation also happening at that time.

My thoughts:

  1. This is really interesting. Its very easy to get confused between inflation and depreciation. In inflation, the aggregate price levels of goods and services rise, so what you can buy with your money drops. The effect is similar to when your currency depreciates, so what you can buy overseas is less. Of course this will cause imports to be more expensive which will increase prices in the country. The impact will depend on how much consumption in the country is fueled by imports.
  2. The main difference is that inflation measures the increase in prices of goods and services sold within the country, whereas the strength of the currency is a separate factor which could impact inflation.
  3. It is theoretically possible, at least in the short-term, for a country to experience all 4 scenarios of high inflation with strong currency appreciation, low inflation with strong currency, high inflation with currency depreciation, and low inflation with currency depreciation.
  4. If price of gold is negatively correlated with currency appreciation, in a sense, gold can be thought of as an “imported good” just like the currency of another country.
  5. Warren Buffett in his annual meeting with shareholders in 2009 and 2010 thinks that there can be significant inflation, and in 2009 thinks that the dollar is going to decline. One good quote from Buffett is: “The best protection against inflation is your own earning power. If you are the best at what you do, you will get your share of the national pie no matter what inflation does. The second best protection is owning a wonderful business that does not need capital. With these guidelines, I’d say invest in yourself. It’s always been the best investment you could make.”

Some readings on Gold:

  1. Understanding Gold by Paul van Eeden
  2. How the price of gold and oil are set
  3. Can the U.S. return to a Gold standard? by Alan Greenspan


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