Precious Metals and Inflation
The term inflation refers to a sustained increase in the price of goods and services. In other words, things are getting more expensive. As goods and services get more expensive, a unit of currency will not buy as much of them. For example, as gasoline prices go up, every dollar buys less gas. As the price of a loaf of bread rises, every dollar buys less bread.
Inflation is always a concern for investors, and many seek out assets that may potentially provide a hedge to inflationary pressures. Gold, silver and other precious metals are commonly discussed with regards to hedging against inflation.
What Drives Inflation?
Although economists generally believe that inflationary pressures are caused by an increase in the money supply, an increase of the money supply does not always stoke inflation. Just look at the United States the past several years. The U.S. Federal Reserve has been increasing the money supply through quantitative easing, and thus far inflation remains benign. The same could be said for the Euro Zone.
Inflation can ebb and flow. Periods of low inflation do not necessarily indicate a new trend in inflationary pressures. These periods of low inflation may simply be caused by temporary events such as supply shortages. That being said, however, when there is an increase in the money supply that exceeds economic growth, a sustained period of inflation may result.
How Do We Gauge Inflation?
There are many different methods for gauging and calculating inflation. The consumer price index, or CPI, and the producer price index, or PPI, both give a good overview of inflationary pressures at both the consumer and producer levels.
The consumer price index gauges changes in a basket of goods and services. These changes are then reflected as a percentage. The consumer price index also consists of sub-indexes and even smaller sub-indexes that are combined and weighted to measure their portion of consumer expenditures. Generally speaking, the rate of change on an annualized basis is used to monitor inflationary pressures; using smaller time frames could lead to misleading information.
The producer price index gauges changes in prices that producers receive for their products or services. Like the CPI, the PPI is made up of a weighted basket. These figures show trends within the manufacturing, commodity and wholesale markets.
How Might Gold and Silver Hedge Against Inflation?
Gold often comes up during discussions on inflation. During the years 1946, 1974, 1975, 1979 and 1980, inflation was at its highest levels since the Second World War. During this time, the average return on the Dow was -12.33 percent while the average return on gold was over 130 percent. While this is impressive, it does not mean that similar results may be seen again. Gold may hedge against inflation, but it is also an imperfect hedge. While gold values could potentially rise or remain more stable during high inflation, there is no telling to what degree it may offer protection from higher prices.
It is also worth noting that the correlation between gold and the consumer price index has largely come apart in recent years. This could be due to many reasons, but the overall lack of inflation over the last decade is likely a large part of this uncoupling.
While inflation has not reared its ugly head in recent memory, there are many reasons to suspect that at some point prices will once again begin to climb. Some of the potential causes for future inflation may include:
- Quantitative easing and money supply expansion
- Sovereign debt issues such as those currently being seen in the European Union
- Loose fiscal policies
- The U.S. dollar resuming its long-term downtrend
Why might gold or other precious metals help? Well, one must understand that when inflation accelerates, one’s real returns become less. In other words, every dollar earned in return buys less goods or services, making the real or net return less. Gold and precious metals may potentially offset all or part of these losses in real return if they increase in value, or even just remain stable.
As stated earlier, there really is no perfect hedge when it comes to inflation. While there are no guarantees, gold and other precious metals may potentially offset inflation or soften the blow. Precious metals are one of the assets of choice when it comes to an inflation hedge due to their ease of acquiring, liquidity and global recognition as a medium of exchange. In addition, some of their past performance during inflationary periods is encouraging.
We do not have a crystal ball and cannot say with any certainty how effective gold or other precious metals may be should inflation come to roost. Because of gold’s long, reliable history as well as its general stability, we believe it is a good choice for investors looking to add some type of potential protection against inflation and a loss of purchasing power.