With global inflation hitting near record levels yet again, amidst other brewing geopolitical and economic events (i.e. war in Europe, tightening financial system, shrinking equity markets, pandemic aftershocks, etc.), is it any wonder why not only individual investors and savers like you and I, but institutions, banks, and countries are all flocking towards the gold market?
Gold is known to be a time-tested, proven inflation hedge, and this reputation is well-earned.
Since inflation means the decrease in the value of fiat (paper, unbacked by metals) money, people turn to assets that proved to be money throughout history – gold & silver. Platinum used to be money as well, but it’s not as recognizable as silver and gold, so the reputation of the ultimate inflation-hedge goes to the former metals, gold in particular (silver being somewhat industrial metal nowadays).
The increase in the prices of goods caused by the increases in the money supply. In connection with this underlying cause, you can also hear terms such as wage inflation and cost inflation. The former looks at the wage component as an inflationary driver, while the latter posits that inflation relates to the increased cost side.
The Causes of Global Inflation
According to Wikipedia – “inflation is a sustained increase in the general price level of goods and services in an economy over a period of time”. Inflation — or, to put it differently, devaluation of world currencies, is a popular issue for a long time, since the USA left the Gold Standard the risks. With interest rates staying low for so long the threat of money inflation has grown hugely.
After a period of decline, inflation has been on the rise since 2020. In September 2021, the annual inflation rate in the United States reached a 13-year high of 5.4 percent. Automobiles, both new and used, are becoming increasingly expensive, as is the gasoline that powers them. And, yes, if you pull up to a drive-through, you can expect to pay more for your burger or burrito. Prices for a wide range of goods are rising as the United States recovers from the pandemic recession.
This can happen for a variety of reasons. The most important ones are as follows:
- The government is increasing the money supply faster than economic growth. When the government injects more money into the economy than it should, people tend to spend more. (Simply put, there is more money trying to buy the same amount of goods, resulting in inflation).
- Imported goods will be more expensive if the currency is devalued.
- When demand for goods rises across the economy, prices rise because supply cannot keep up.
- A rise in the cost of production and raw materials can raise the price of goods in the economy.
- When the national debt rises, governments either raise taxes or print more money, causing inflation to rise even more.
Inflationary pressures have a wide range of economic ramifications. To begin with, it reduces purchasing power by raising the cost of retail goods and services. Borrowing costs may also rise as interest rates rise due to increased risk. Inflationary pressures can also fuel further inflation, resulting in a feedback loop. As people spend more quickly in order to reduce the amount of time they spend holding depreciating currency, the supply of money exceeds the demand, causing the currency’s purchasing power to fall even faster.
Consequently, we can observe high positive correlation between inflation and gold price. Please take a look at the chart below to see how closely two values are tied:
As you may see on the above gold and inflation chart, when inflation rises, gold rallies. As we have mentioned earlier, inflation is the increase in prices of goods caused by the increases in the money supply, so analogous relationship should be visible also between gold and money supply.
Clearly, gold and money supply tend to move in the same direction.
At this point you may wonder whether gold moves up more than prices of other goods. Naturally, that is the case – otherwise, gold would not be an inflation hedge. However, gold price doesn’t really outperform prices of other assets at the first stage of the bull market. The first stage of the bull market is also known as the “hidden stage” because it’s visible primarily from the USD perspective. In other words gold priced in other currencies moves back and forth, without any long-term uptrend. The second stage of the bull market is where gold fueled by inflation truly starts outperforming prices of most assets and it’s rally is visible also from non-USD perspectives. In this bull market, the second stage begun in 2006.
Taking inflation out of the gold price fluctuations allows us to see if gold is indeed in an uptrend. After all, if an asset (like stocks) are not keeping up with inflation, investors holding it will really lose money. This perspective also allows us to see if the bull market is truly in place.
As you may see, inflation-adjusted gold price is in a clear uptrend. The additional fact that we can observe on the above chart, is that gold is still far from its 1980 high, which suggests that gold has more room to go before the bull market is over.
Why Does Inflation Increase Gold Price?
During inflation, the costs of consumer goods increase and become more expensive., thereby making the dollar lose value. Since gold is dollar-denominated, its price also increases in line with the rising inflation.
This makes gold a good hedge against inflation as investors would be converting their cash holdings to gold to protect the value of their assets. The increased interest from investors may set off a bull cycle in gold until the effect of inflation begins to cool off.
We have already written about the advantages of gold as an investment and no doubt it’s great protection against inflation. The initial effect must do with inflation is that it lowers the worth of each other dollar in circulation when creating more fiat currency.
The next effect that inflation has on the price of gold entails conjecture and market sentiment. News junkies are most likely conscious that every time the Federal Reserve mentions interest rate rises, gold costs soar.
Basically, it’s all about the resources. When inflation is raising its head, our money worthless. As a result, the value gold, commodities and other cryptocurrencies such as Bitcoin increase. They have no dependence in any central bank – since these resources are limited, and that’s exactly the point.
Why is Gold Considered an Inflation-Proof Investment?
The price of gold increases with the value of inflation because it is a dollar-denominated commodity. Inflation is characterized by an increase in the prices of goods and services which is driven by a rise in the costs of commodities and products.
As inflation rises, consumer goods become more expensive. Because the price of gold is denominated in dollars, this means that its value would increase with the rising inflation rate.
Historically, gold has been used as a safe asset to combat inflation. Because its supply is limited and it is a tangible commodity, its value tends to hold during periods of high inflation. As a result, older people who have seen gold withstand inflation on multiple occasions tend to buy gold when they suspect inflation is on the horizon.
How to Invest in Gold without Purchasing Physical Gold
Buying and holding physical gold, on the other hand, can be inconvenient and costly. Fortunately, there are several ways to own gold without physically possessing it:
- Gold mining stocks – Investors can also invest in gold indirectly by purchasing stock in gold mining companies. These firms tend to follow the movement of gold in the spot market. As a result, they may provide investors with indirect exposure to gold.
- Derivatives – Gold can be purchased by investors through derivatives such as forward contracts. Derivatives are financial instruments whose value is derived from the underlying asset. CFDs, Futures Markets, and Forward contracts provide investors with indirect exposure to gold without requiring them to own the commodity physically.
- Receipts from Gold Depository Institutions – Gold depository receipts are a legal document issued to the owner of a futures contract in exchange for the storage of gold in a vault. The receipt allows the holder to redeem his gold from the vault at a later date, though this is almost never the case. Holders can always exchange their paper receipts for cash in the spot market because the number of receipts exceeds the amount of gold in the bullion.
- Gold Mutual Funds – Gold funds are a viable method of investing in gold. These are actively managed funds by fund managers that are designed to track gold prices. They are a low-cost and cost-effective way for investors to gain exposure to gold through mutual funds or gold ETFs, which are traded on stock exchanges like shares.
The amount of official reserve assets held in Gold have increased to $494 billion as of 2020, according to data from the FED. The reserve assets held in gold increased from $134 billion in 2005 to $433 billion in 2012. However, the reserves fell by $118 billion in 2013 to $315, then to a further $277 billion in 2015. The government then increased the reserve assets held in gold from 2016 to 2020, when the reserves attained a 20-year peak of $494 billion in asset reserves.
Can Bitcoin Also Provide a Hedge Against Inflation?
Bitcoin, like gold, has a finite supply. This is the primary reason why they are thought to be unaffected by inflation. Governments are unable to “print” Gold or Bitcoin. Only by mining can you increase their supply, which happens at a constant rate.
Gold and Bitcoin are high-risk investments. People who invest in them frequently do so not for their intrinsic value, but rather to protect their capital during times of adversity.
Both gold and Bitcoin are unforgeable. Bitcoin transactions are recorded on a public ledger, and more currency cannot be added to the ledger. Gold is easily identified and its purity can be determined.
Finally, both gold and Bitcoin are nearly indestructible. Gold is prone to wear and tear if not handled with care. It will, however, never disappear. The only way for a cryptocurrency to disappear is for the entire world to lose internet access for an extended period of time.
Other Inflation-Proof Investment Alternatives
Besides investing in gold (and bitcoin), there are a couple of alternatives that can provide a hedge against inflation:
Essentially, the Treasury Department uses the Consumer Price Index to adjust the value of the principal to reflect the effects of inflation (CPI). This instrument is paid a fixed rate of interest on the adjusted principal twice a year. When the child reaches adulthood, the final adjustment takes place.
If the principal’s value has risen due to inflation, the investor will receive the higher, adjusted amount back. However, if inflation has reduced the value of the security, the investor will receive the security’s original face value.
- Real Estate
The rental of a property generates real estate income. In the face of inflation, real estate performs well. This is because as inflation rises, so do property values and the amount of rent a landlord can charge. As a result, the landlord’s rental income will increase over time. This helps to keep up with inflationary pressures. As a result, real estate income is one of the best ways to guard against inflation in an investment portfolio.
Real estate can keep up with inflation because of the scarcity of it. People will always need to live in houses or apartments, so investors in this asset class will be able to keep up with inflation. Everyone uses real estate, regardless of the state of the economy or the markets. And, while returns may fall, overall (real estate) will be more stable and a relatively quick recoverer once things begin to improve
- Other Types of Commodities
Given the volatility of the commodities market, experts recommend investing in commodities through a diversified investment vehicle such as a mutual fund or exchange-traded fund. Prices for raw materials such as oil, metals, and agricultural products typically rise in lockstep with inflation, making them an excellent inflation hedge.
During uncertain economic periods such as inflation or recessions, silver is viewed as a safe haven investment. As a result, the precious metal is an excellent hedge against inflation and stock market declines. As a result, with inflation at an all-time high in the United States, investing in silver allows investors to protect their portfolio investments from the corrosive effects of inflation.
Investors should be aware, however, that commodities can be extremely risky. Commodity prices are heavily influenced by supply and demand, both of which can be volatile. This, combined with the fact that investors are using leverage, makes them a risky investment: the possibility of rewards is high, but so is the risk of losses.
Clearly, inflation has a direct effect on the price of gold. If you think that inflation will only worsen in the coming years then a gold investment might be something worthwhile for you to research (See what are the best ways to invest in gold).
If you don’t see a problem with the U.S. Dollar Index’s trend then you might not feel a need to own gold. Undoubtedly, however, change in the US inflation has an immediate and significant effect on the price of gold and other precious metals.
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