Gold and Inflation: A Risky Bet

Gold investors are of the opinion that inflation is bullish, and many of the metal’s lingering supporters are betting that central bankers will make inflationary decisions. But central bankers are growing increasingly wary of doing so. And even if they do, the outcome may not be what market participants expect.

Inflation is the erosion of purchasing power, a situation where a currency buys less than it once did. As a hedge against inflation, gold guards against that loss in value.

In theory, if you purchase $1,000 worth of gold at a time when that chunk of metal can buy 1,000 loaves of bread, in the future, no matter how much bread prices have increased, you should still have the ability to get 1,000 loaves.

There is an undying debate as to whether gold truly acts in this capacity. The World Gold Council (WGC) says it does. The WGC believes that despite all challenges gold has retained its purchasing power, and insists that economists have shown that to be true over the long term through both inflationary and deflationary periods.

Investors in the gold space are seeking this type of security. Their primary concern is to ensure a return on their capital. So, if the WGC is correct, those individuals appear to be on the right path.

However, these investors’ ideas about inflation may prove to be riskier than they realize.

Global growth is slowing quite rapidly due to the Eurozone crisis, and that is actually deflationary, says an annual inflation assessment produced by Richard Barkham, group research director at Grosvenor.

“Our conclusion is that there is no evidence of a build-up in inflation in the world economy,” the report says.

But market participants are vying for central banks to take action that could be inflationary. They want central bankers to douse economies with monetary stimulus. Doing so, the argument goes, will debase the currencies in those economies, thereby driving individuals to acknowledge gold as a safe haven.

“Forthcoming monetary easing to be taken by central banks are likely to spark higher inflation rates, which should benefit gold as a store of value,” states a research note from Commerzbank.

Similarly, Barclay’s analyst Suki Cooper is quoted in the London Gold Market Report as saying concerns over inflation and potential monetary easing bode well for gold.

But central bankers are holding off on easing measures, in part because they are wary of inflation.

Last week, gold rose as investors expected that a lower-than-expected rate of Chinese inflation could prompt stimulus. However, the Chinese central bank took no such action.

“The [Chinese] central bank is still concerned about a rebound in inflation and it is relucatant to loosen too much on the liquidity side,” said Xu Gao, an economist at Everbright Securities and former World Bank employee.

On Tuesday, the US Labor Department released Producer Price Index data for July that exceeded expectations. That, coupled with stronger-than-expected retail sales data, weighed on gold prices as the news is considered unlikely to nudge the Federal Reserve toward QE3.

Central bankers are increasingly weighing the risks of unwanted inflation against the true impacts of stimulus. One problem that central banks have to wrestle with is that the monetary easing measures that they have employed thus far have given them little control over where the money goes after they create it. As a result, central bankers are now having to acknowledge that stimulus can fail to stimulate where needed.

Jeffery Lacker, president of the Richmond Federal Reserve bank, opposed an extension of Operation Twist on those grounds. “A significant increase in inflation could threaten the Fed’s credibility and make it more difficult to achieve the Fed’s long-run goals,” he said.

Another problem for gold investors expecting to benefit from inflationary measures is that although some central bankers are concerned about adverse effects, there is no guarantee as to what will happen.

People often discuss inflation as if it is an individual with predictable moods, but that is not the case.

“The relationship between inflation and the money supply is quite uncertain in the short and medium term but, given the recent massive expansion of the central bank balance sheets, it is worth keeping an eye on,” Barkham’s report says.

Even if central banks ease, the temporary boost from stimulus that gold investors could benefit from will likely be short lived.

The markets largely seem to ignore that this current addiction to stimulus has tended to play out like an addiction to anything else: you get a high, but revert back to being a fiend if you do not get another hit. The currently-awaited bout of quantitative easing from the Fed is referred to as QE3.

The gold market has yet to sustain itself on just monetary policy, and the inflation that many have predicted has yet to materialize.

Securities Disclosure: I, Michelle Smith, hold no direct investment interest in any company mentioned in this article.