Gold and inflation: myths and realities

It has become a cliché, a commonplace: “gold protects against inflation”. You have probably read it in the financial press, or heard it from commentators. Or seen it on television, as in a report on savings and inflation on the TF1 evening news on 23 March, where someone explained having cashed in a life insurance policy to put everything into the yellow metal. It is worth stepping back. Because as with any cliché, there is a grain of truth in it: yes, the gold price and inflation are closely linked. But there is also a hasty shortcut: no, the relationship is neither systematic nor linear.A store of value over the (very) long termInflation is above all the erosion of the purchasing power of money. In a 2013 paper[i] well known to specialists, two American researchers showed that gold offered good protection against inflation over the very long term. They take the example, updated here, of a Roman centurion, who in terms of responsibility is the equivalent today of an infantry captain. Under the emperor Augustus, that centurion was paid 3,750 denarii a year, or about 38.5 ounces of gold, which would represent $73,000 today. That is more or less the same as an American infantry captain with four years of service[ii], $74,220 in 2022. Gold has therefore held its value over two thousand years despite inflation, and despite crises, wars and the rest. A quite remarkable property, but unfortunately short on practical implications: nobody has an investment horizon of several centuries.Inflation explains only 16% of gold’s historical movesLet us look less far back. In a recent study, the World Gold Council analyses the link between the gold price and inflation in the United States since 1971, the year the gold standard ended. The verdict: over more than fifty years, the correlation, which measures the statistical link between the two variables, is only 16%. We have carried out a similar analysis on the price of the metal in euros, since the single currency was created in 1999, which therefore excludes the distant impact of the oil shocks. It also shows that monthly moves in the gold price are not correlated with the level of inflation in the euro area, which is likewise published monthly.Ceteris paribusThat is no reason to throw the baby out with the bathwater. Specialists know it: gold is strongly and inversely correlated with the level of real interest rates, that is, interest rates less the rate of inflation, or more precisely less inflation expectations. The correlation is so strong that it is obvious on a chart. The gold and inflation link is therefore indirect: if inflation rises, all other things being equal, real interest rates will fall and it is statistically likely that the gold price will advance. The catch is that “all other things being equal” which economists and commentators often forget to mention. In the real world, an economic variable never moves on its own. Everything moves all the time. And typically, when inflation rises, nominal interest rates tend to rise too, which more or less holds real rates where they were. Unless stagflation sets in.Stagflation: a possible scenario…Stagflation is the combination of entrenched, high inflation and a flagging economy that prevents rates from being raised without causing a recession. The picture matches the risk Europe currently faces, despite the reassuring words, or the pious hope, of Christine Lagarde. Early in the year, economists were already revising down their growth forecasts for 2022. The IMF announced it would lower its projections in the spring because of the war in Ukraine, which is already weighing on the morale of consumers and businesses on the old continent. It is also likely that inflation will become structurally and lastingly higher than in the past. Securing strategic supplies, in food, technology, energy and so on, including by bringing production home, will inevitably raise costs. This is the end of “imported disinflation”, a phenomenon tied to globalisation that allowed us for thirty years to keep prices low thanks to low-cost Chinese factories.…and one that favours goldMany have in mind the stagflation of the 1970s, and in particular its two oil shocks, which caused recession, unemployment and a spectacular rise in prices. Under the effect of sharply negative real interest rates, the gold price was multiplied by 2.5 in each episode. But comparison is not proof: the economy and finance today are radically different from fifty years ago, and a surge in the metal of the same magnitude is unlikely. Let us stay reasonable and conclude that gold is a good candidate for spreading risk and for protecting oneself over the long term against the risk of lasting, high inflation that brings economic trouble with it. [i] The golden dilemma, Erb & Harvey (2013), link [ii] Captain, grade O3, with four years of service, source: US Department of Defense pay scale