Relationship Between Inflation And Gold Index
Sonya Schmiesing
The impact of inflation and the value of the dollar can be seen in the recent price action of gold. As inflation soared in 2022, the price of gold actually declined throughout much of the year, partly owing to the strength of the dollar against other world currencies. However, after hitting a low of less than $1,630 per ounce in September and October 2022, the price of gold began to recover, with the persistence of inflation and concerns about a recession bolstering prices throughout the fourth quarter and into 2023.
Although the metal has proven its capacity to maintain its value over time, the price of gold is often volatile over the short term. There are many factors that influence the price of the metal. Because gold is generally dollar-denominated, a stronger U.S. dollar tends to drive gold prices lower, and vice versa. Real and expected inflation rates also affect the price of the metal. Gold purchases by central banks have an impact on the price, as does demand for gold to be used in jewelry and technological devices.
Gold adds an important layer of diversification to an investment portfolio because it has shown a negative historical correlation with other asset classes. In other words, when investments such as stocks and bonds falter, gold has a tendency to outperform. Investment exposure to gold is useful to hedge against inflation and to add a measure of safety to your portfolio in difficult economic times.
Despite market lore that gold is a good hedge against inflation, the reality is much more mixed, meaning the two are essentially uncorrelated. This can be seen in the chart above, where inflation spiked in 2022, but gold retreated as interest rates rose.
But the Bretton Woods system had a number of flaws in its implementation, chief among them the attempt to maintain fixed parity between global currencies that was incompatible with their domestic economic goals. Many nations, it turned out, were pursing monetary policies that promised to march up the Phillips curve for a more favorable unemployment-inflation nexus.
As inflation drifted higher during the latter half of the 1960s, US dollars were increasingly converted to gold, and in the summer of 1971, President Nixon halted the exchange of dollars for gold by foreign central banks. Over the next two years, there was an attempt to salvage the global monetary system through the short-lived Smithsonian Agreement, but the new arrangement fared no better than Bretton Woods and it quickly broke down. The postwar global monetary system was finished.
Over time, greater control of reserve and money growth, while less than perfect, produced a desired slowing in inflation. This tighter reserve management was augmented by the introduction of credit controls in early 1980 and with the Monetary Control Act. Over the course of 1980, interest rates spiked, fell briefly, and then spiked again. Lending activity fell, unemployment rose, and the economy entered a brief recession between January and July. Inflation fell but was still high even as the economy recovered in the second half of 1980.
Beyond cash, our inflation variables explained a statistically meaningful amount of return data for commodity futures, gold, inflation-linked bonds, Treasuries, and investment-grade bonds. In fact, regarding the first two asset classes mentioned, almost half of the performance data was linked to inflation, according to our model. Of the remaining four asset classes, which are US equities, US REITs, international equities, and natural resources equities, no one asset class had a statistically meaningful relationship with this inflation model over this time period.
Of the four other asset classes with meaningful relationships to inflation, only two had positive relationships with inflation rate changes. They were inflation-linked bonds and Treasury bills. For the latter, the 0.4 beta is likely related to the lag in time associated between US Federal Reserve policy rate decisions and changes in inflation. The two other asset classes, which were investment-grade bonds and Treasuries, both reacted negatively to changes in the inflation rate. This result makes sense, as higher inflation levels tend to prompt the Fed to raise its policy rate, putting pressure on longer-dated rates and credits.
To better understand the relationship between our assets and inflation, we divided the 47-year period into two halves and re-analyzed the data. This sanity check helps us gain insight on whether assets respond differently to different types of inflation. For instance, the first period (1973 to 1996) was characterized by an average inflation rate of 5.7%, while the inflation rate of the second period (1997 to 2019) was just 2.1%. Similarly, the volatility [or magnitude] of inflation rate changes shrunk by nearly half from the first period to the second period.
The results of the time period check suggest two nuances are needed. First, many assets that had a meaningful relationship with our inflation model in the first period did not have one in the second period. This was true for US equities, Treasuries, investment-grade bonds, and gold. These assets, which all had negative relationships with inflation in the first period except gold, were seemingly overwhelmed by volatile inflation in the first period. The tame inflation environment of the second period permitted other factors to drive the performances of these assets.
The unfortunate truth about the two most inflation-sensitive assets in our review is that their long-term performance has been terrible. Across the 47-year period, commodity futures and gold returned an annualized 5.6% and 7.0%, respectively, which rank as the lowest two performances besides Treasury bills across the assets in our review. Furthermore, these assets were the most volatile, meaning their risk-adjusted returns were much lower than the other assets. What seems to be clear is that a trade-off between sensitivity to inflation rate changes and risk-adjusted returns exists (Figure 4).
The results are striking (Figure 6). Inflation-linked bonds led, outperforming inflation 93.8% of the 1,000 samples, with the other fixed income assets bunched in the top half. Equity assets followed. While these assets were generally less consistent than the fixed income assets, their average levels of outperformance were higher. For instance, when REITs outperformed inflation, they did so by an average of 11.0 percentage points (ppts). Commodity futures and gold were the least consistent performers, with the former underperforming inflation 41.5% of the time by an average of 8.0 ppts.
In the first half of 2022, for instance, demand for gold increased 12% year over year. Consumer prices rose 9.1% over the 12 months that ended in June 2022. Research shows that between 1974 and 2008 there were eight years when U.S. inflation was considered high. During those periods, gold prices rose by an average of 14.9% year over year.
Oil price shocks and energy shortages drove average annual U.S. inflation up to around 8.8% from 1973 to 1979. During those six years, gold won over many investors as a top inflation hedge, since the yellow metal generated an impressive 35% annual return.
From 1980 to 1984, annual inflation averaged 6.5%, but gold prices fell 10% on average each year. Returns not only fell short of the inflation rate, but they also underperformed real estate, commodities and the S&P 500. Annual inflation averaged about 4.6% from 1988 to 1991, but gold prices fell approximately 7.6% a year on average.
But that leg up followed a relatively weak performance in 2021 and 2022. The consumer price index (CPI), a popular measure of U.S. inflation, gained 4.2% year over year in April 2021, its first annualized gain of more than 4% since 2008. While the average annual U.S. CPI growth was around 6.8% during those years, gold prices eked out an average annual growth rate of only 1% over the same period.
Some cryptocurrency investors argue that crypto is the best inflation hedge because its supply is fixed. Central banks worldwide are free to increase the supply of money at will and miners can dig up more gold, but the total amount of Bitcoin and some other cryptocurrencies is strictly capped.
There have been certain periods in the past when the price of gold rose faster than inflation, this has not always been the case. Rising prices throughout the economy are only one factor that influences the price of gold. Other key categories include supply of gold, investor sentiment and other commodity market dynamics.
Although gold has proven its long-term value over thousands of years, there are other options. For example, since 1973, energy stocks have been the top-performing sector during periods of high and rising inflation. Other best inflation stocks include defensive sectors, like utilities, consumer staples and health care.
An investment that hedges against inflation would generally rise along with the rapid growth in consumer prices. However, gold yielded a negative return for investors during some of the highest recent inflationary periods in the U.S.
Investors often turn to gold as a way to diversify portfolios amid financial market volatility. Gold historically has a low correlation with broad U.S. stock and bond exposures. In the last 20-years, monthly price correlation between gold and the S&P 500 was 0.09, meaning there was virtually no correlation between stocks and gold; correlation between gold and the Bloomberg US Bond Aggregate Index was 0.38, showing little to no historical correlation.5
Many investors view gold as an inflation hedge when, in truth, the relationship between gold and inflation is nuanced. As noted above, gold has tended to trade in closer relationship to real rates and the dollar vs. inflation per se. Notably, spot gold prices were rangebound in 2021, when U.S. inflation rates surged.6
Gold prices hit an 18-month low in October. The U.S. Federal Reserve raised its key policy interest rate seven times in 2022 by a combined 4.25 percentage points, reaching its highest level in 15 years. The U.S. dollar has also appreciated sharply, with the dollar index rising to its highest level in two decades. Investment demand for gold has therefore weakened considerably, with continued net outflows in gold-backed exchange traded funds (ETFs). Soft jewelry demand, most notably in China due to on-and-off pandemic restrictions, also weighed on gold prices. These factors have more than offset robust central bank purchases.
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