Is gold actually an inflation hedge? Does it need to be?

[Pointedstick]

So Harry Browne posited four economic conditions: prosperity, recession, inflation, and deflation. Supposedly gold is our asset that does well during inflationary periods.

But how true is this? Gold was very volatile during the 70s but then fell for 20 years, even during a period of mild inflation. Today inflation is minuscule but gold is going bananas. How does this make any sense?

Gold appears to be much more strongly tied to interest rates than inflation. Specifically, real rates, as posited by Robert Barsky and Lawrence Summers (PDF link). So if they're right, then the reason why gold is doing great is because we're in a period of negative real rates.

This is actually great, because nothing else in the PP protects me against negative real interest rates! Stocks will be doing their own thing, cash is losing, and bonds may be returning coupon payments that beat inflation, but just barely.

This explains why gold and bonds have both been doing great recently. We have deflation AND negative real interest rates! Using the traditional Harry Browne explanation requires much more mental gymnastics to explain how we have both net inflation and net deflation at the same time.

So what protects against inflation? Now, this is hard for me as a liberterian to accept, but why should I actually even care about inflation as long as I can still earn a positive real rate of return? If my money is losing its purchasing power at a rate of 6% a year, but T-bills are paying me 7%, what's the problem? It's in fact the cash portion of the PP that protects me against inflation, not gold!

It seems like it might be worth it to add another set of economic conditions related to interest rates, since the current four conditions omit the real winner for gold.

Prosperity: stocks
Recession: cash
Inflation: cash
Deflation: bonds

Rising interest rates: cash
Falling interest rates: bonds
Negative real rates: gold
Positive real rates: bonds and cash

Inflation usually involves rising interest rates, and deflation does the opposite, so we can consolidate a bit:

Prosperity: stocks
Recession: cash
Inflation (rising interest rates): cash
Deflation (falling interest rates): bonds
Negative real interest rates: gold
Positive real interest rates: bonds and cash (?)

Am I crazy??? Does any of this make sense?

[melveyr]

I would listen to Harry Browne's radio shows again. He does appear to be making a real interest rate argument for gold (not using those exact words though!)

He says that when investors are worried about the economy, the first place they flock to is Treasuries. However, if the dollar is threatened by inflation then investors turn to gold.

That strikes me as a real interest rate argument because he essentially saying that investors only turn to gold if they are not happy about what is happening with the Treasury market.

[MediumTex]

I would listen to Harry Browne's radio shows again. He does appear to be making a real interest rate argument for gold (not using those exact words though!)

He says that when investors are worried about the economy, the first place they flock to is Treasuries. However, if the dollar is threatened by inflation then investors turn to gold.

That strikes me as a real interest rate argument because he essentially saying that investors only turn to gold if they are not happy about what is happening with the Treasury market.

When you cut your teeth in a period of actual high inflation accompanied by negative real interest as Harry Browne lived through in the 1970s, I'm sure it just becomes a habit to refer to "inflation" as a catch-all concept to describe any period where bondholders are not being compensated for the effects of inflation, whatever that rate of inflation happens to be.

I run across a lot of small ways in which Harry Browne was not as articulate about some of these matters as I would have liked, but I think that his overall thinking and conclusions are completely sound and as you explore them and begin to appreciate their subtleties, they seem more and more like the work of a genius.

[AgAuMoney]

I run across a lot of small ways in which Harry Browne was not as articulate about some of these matters as I would have liked, but I think that his overall thinking and conclusions are completely sound and as you explore them and begin to appreciate their subtleties, they seem more and more like the work of a genius.

Or a really clever intuitive problem solver who was able to solve problems without ever really understanding the full scope of the problem or of the solution.

[Gosso]

Prosperity: stocks
Recession: cash
Inflation (rising interest rates): cash
Deflation (falling interest rates): bonds
Negative real interest rates: gold
Positive real interest rates: bonds and cash (?)

Am I crazy??? Does any of this make sense?

Makes sense to me.  Although I would add stocks to the positive real interest rate scenario, since positive rates indicate that the economy is strong and that bonds/cash are trying to compete with the stock market, (although it could mean the currency is in trouble, in which case gold/foreign currencies would do well).  After trying to think all of this stuff through it eventually becomes a bit overwhelming.

I think Harry did a great thing in identifying the four spokes of the wheel that hold our economy together.  As long as M2 is growing then that money will find its way into one of the four assets.

[MetalQuick.com]

It's in fact the cash portion of the PP that protects me against inflation, not gold!

No, by its definition, inflation results in the devaluation of cash. The dollar buys less, so cash is not a good place to store you wealth during inflationary periods. Virtually any "good" would be better. In theory you could buy canned food as a store of wealth. Here's an example:

Let's assume we are at day 100 of a 600 day inflationary period and track the price of a can of peas, and then contrast if you'd have more wealth holding cash or cans of peas. Let's assume we are starting with $1,000.

Day 100: Can of peas costs: $1 and you buy 1,000 cans
Day 600: Can of peas costs: $1.25, you sell your 1,000 cans, you now have $1,250.

If you kept your wealth in cash the entire time, you'd only have $1,250. So investing in peas resulted in building your wealth by 25% more than simply holding on to cash.

So you could do this in theory with any good, as during inflation it is the general prices of all goods that rise, but the trick is to obviously find the "good" that will rise the most as not all goods inflate at the same rate (inflation nbrs represent an average, fuel may rise 20% and clothing only 10%).

Gold is typically viewed as an inflation hedge and hence has a lot of demand during these times, which results in a supply/demand shift that is greater than that of a can of peas. As such it will benefit in a premium over the inflation rate.

Interest Rates

To look at this deeper, at how interest rates come into the equation...

Inflation (rising interest rates): cash

No, inflationary periods do not mean rising interest rates, normally just the opposite. (Though inflation can be caused by many factors which all result in a situation in which there is higher demand for goods.)

Low interest rates allow banks to essentially borrow free money from the Fed Reserve, they then loan it out at some rate and make the margin as profit. Hedge funds borrow from the banks at a low rate (3%), invest in stocks and make 10%, and make the 7% as profit...all this money going into the market raises the general price of stocks, making people wealthier, making them buy more, which drives up prices, causing inflation.

Or in another example, lower interest rates mean you can afford a more expensive home on the same payments. Sellers know this and start raising the prices of their homes to adjust for it, resulting in the increase in home prices.

So to sum up, I'd simplify it as such:
Low interest rates creates ---> Inflation which drives up ----> gold prices.

During deflationary periods, the opposite occurs.
High interest rates creates ---> Deflation which drives down ----> gold prices.

This is why the federal reserve has so much power since we have a fiat currency.

[Ad Orientem]

I think the important thing to remember about gold is that it is a currency. When measured against the dollar you are going to have fluctuations but in general it does well when the dollar is being debased. HB was pretty sympathetic to the Austrian view on inflation and that is not the same thing as CPI. To an Austrian inflation is when you are creating more money. Also it's worth noting that while we did have higher inflation in the 80's and 90's as measure in CPI this was in general a period of economic prosperity. We had a strong secular bull market in equities with both inflation (monetary and CPI) and unemployment steadily declining over those two decades. So one would not expect gold to favorably react to that.

In a period of economic prosperity with declining overall inflation you want to own stocks and bonds.

[stone]

So what protects against inflation? Now, this is hard for me as a liberterian to accept, but why should I actually even care about inflation as long as I can still earn a positive real rate of return? If my money is losing its purchasing power at a rate of 6% a year, but T-bills are paying me 7%, what's the problem? It's in fact the cash portion of the PP that protects me against inflation, not gold!

How does that jive with Zimbabwe or post WWII Germany? I would not wanted to hold cash in either of these hyperinflation scenarios. I think hard assets, real estate, etc would be a better option. Or food.

I'm sure I read something about the Chile hyperinflation saying that asset prices crashed. People were selling houses for the cost of passage out of the country

[stone]

I've never seen a plot of the Indian median wage in USD alongside the gold price. I've a hunch though that there would be a pattern there.

[Gosso]

I've never seen a plot of the Indian median wage in USD alongside the gold price. I've a hunch though that there would be a pattern there.

China M2 and gold.

[Ad Orientem]

I've never seen a plot of the Indian median wage in USD alongside the gold price. I've a hunch though that there would be a pattern there.

China M2 and gold.

Any and all economic figures issued by China should be taken with more than a grain of salt.

[MediumTex]

It's in fact the cash portion of the PP that protects me against inflation, not gold!

No, by its definition, inflation results in the devaluation of cash. The dollar buys less, so cash is not a good place to store you wealth during inflationary periods. Virtually any "good" would be better. In theory you could buy canned food as a store of wealth.

Note that when we say "cash" in the context of the PP, what we mean is really "t-bills." 

When you look at the return t-bills have provided in the last 40 years it has been in the 5%+ range, while inflation has averaged around 4%+.

Thus, PP "cash" in the form of t-bills has more or less kept pace with inflation over the last four decades, but has provided almost no real return, whereas the PP has provide around a 4.25% real return over that same period.

There were years during that 40 year period where t-bills DID provide a positive real return (such as in the mid-1980s through the 1990s), but there have also been extended periods when they didn't.

Some people will say that just buying t-bills gives you PP-like returns over time.  That is not true.  It is only true if you cherry pick the data.  If you simply look at the 40 year life of the PP, you see a large difference between "cash" in the form of t-bills and the overall PP.

[Gosso]

Any and all economic figures issued by China should be taken with more than a grain of salt.

That can be said for any government statistic.  But I agree that China is likely the greatest offender in that regard.

All I'm suggesting in the chart is that maybe it is not negative rates that have caused the increase in gold, but the growth in China and India...as stone hinted at.  Bottom line: I don't know.  But I still want a large chunk of gold in my portfolio, due to its history as a reliable currency.

Although, I still think negative rates play a very strong role in the price of gold, which makes it extremely important in a diversified portfolio.

Have a look at this chart:



Gold and the Dow track US M2 very nicely.  Although I believe that gold is better represented by global M2 growth.

[MachineGhost]

Am I crazy??? Does any of this make sense?

Economic Regimes

Stocks: Inflation
Reflation

Bonds: DisInflation
Revaluation

Cash: Inverted Yield Curve
Deflation

Gold: Depreciation
Devaluation
Hyperinflation
Negative Real Rates

[MachineGhost]

MachineGhost, could you explain that one?  I'd probably use currency appreciation/depreciation as we're talking about floating currencies - but I wonder if it actually tracks revaluation directly. 

Revaluation typically happens under currency pegs.

[systemskeptic]

Is the Dollar an inflation hedge?  Yes, against inflation in Euros.
Is the Euro an inflation hedge? Yes, against inflation in Dollars.
Is Gold an inflation hedge?  Yes, against inflation in any/all currencies.

IMHO, the concept of an inflation hedge misses the point.  What you really mean to hedge against is currency exposure. Currency exposure involves a series of risks not limited to inflation (devaluation, hyperinflation, unfavorable yield curves, exchange rate risk, etc).

Euros, USD, Yuan, etc. pay interest in order to offset inflation.  A better way to view gold is a currency which does not inflate, thus does not need to pay interest.  

[melveyr]

Another component to inflation that is often ignored are supply shock induced. It isn't always a monetary phenomenon (I wish Friedman never said that was, it is too catchy). Hypothetically if the world's oil supply got cut in half overnight, the only hedge against that inflation would be holding raw commodities themselves (especially oil!). There is no currency that would benefit from that situation.

Inflation is a really broad term that can be caused by so many different factors.

[systemskeptic]

To go one step further, the concept of an "inflation hedge" does not make sense.  Inflation is merely the metric by with you judge the performance of your portfolio [as measured in that currency].

What would a 10% return in $USD mean without knowing the rate of inflation in $USD over the same time frame?

[HB Reader]

I would listen to Harry Browne's radio shows again. He does appear to be making a real interest rate argument for gold (not using those exact words though!)

He says that when investors are worried about the economy, the first place they flock to is Treasuries. However, if the dollar is threatened by inflation then investors turn to gold.

That strikes me as a real interest rate argument because he essentially saying that investors only turn to gold if they are not happy about what is happening with the Treasury market.

When you cut your teeth in a period of actual high inflation accompanied by negative real interest as Harry Browne lived through in the 1970s, I'm sure it just becomes a habit to refer to "inflation" as a catch-all concept to describe any period where bondholders are not being compensated for the effects of inflation, whatever that rate of inflation happens to be.

I run across a lot of small ways in which Harry Browne was not as articulate about some of these matters as I would have liked, but I think that his overall thinking and conclusions are completely sound and as you explore them and begin to appreciate their subtleties, they seem more and more like the work of a genius.

I agree with both of these observations.  When I started investing in the mid-1970s, my biggest fear was the potential failure of the dollar to maintain its traditional role as a store of value.  That danger presented itself both through high official inflation rates and the almost complete lack of any near cash savings investment options (there were few alternatives to fixed-rate bank savings accounts for most investors then) that compensated you for inflation.  In other words, most of us were experiencing negative real interest rates.

The removal of Regulation Q (which effectively deregulated the short term money market in the US in the late 70s/early 80s) and the development of money market funds and bank accounts made it possible to hold near cash savings in ways that you could receive "free market" interest rates that compensated for inflation.  I think these developments served to blunt the store of value concerns of many or most average investors of that era.   

Today, however, we have "free market" interest rates that are manipulated (depressed, I believe) by massive central bank intervention.  Whether or not this is wise economic policy is the subject of a different discussion, but it presents holders of near cash savings with essentially the same problem they faced in the 1970s -- negative real interest rates on near cash savings.  Under these conditions, that many investors both in the US and across the world are looking to an alternative to the dollar (still the world's favorite currency) does not seem that surprising to me.

Obviously HB, like any other person, couldn't predict exactly how the future would unfold.  But it seems clear to me that he had a pretty good grasp of how large scale central bank manipulation of currencies and interest rates might have broad effects in the long run on savers and investors.     

 

             

[Wonk]

I agree persistent negative real interest rates are the primary driver of gold prices--not inflation rates.  Let's assume for a moment that the Fed had a directive to always keep real interest rates positive.  Would there be any strong incentive to purchase gold?  Probably not.  We had a period of positive real interest rates from 1980-2000 and interest in gold was nearly non-existent.

[melveyr]

I agree persistent negative real interest rates are the primary driver of gold prices--not inflation rates.  Let's assume for a moment that the Fed had a directive to always keep real interest rates positive.  Would there be any strong incentive to purchase gold?  Probably not.  We had a period of positive real interest rates from 1980-2000 and interest in gold was nearly non-existent.

If you pull up the trade weighted dollar index and plot gold against it, the US negative interest rates and the spikes in gold don't entirely match up.  You would have expected more of a jump in 2002-2005.  But if you look against the euro, then it kinda makes sense why it was delayed until the end of 2005.  

I'm a bit concerned over the role of gold in the PP of late - especially as there are now more viable reserve currencies out there than just the eurodollar.  The 'fear' component no longer aligns with the contribution from the rest of the classic PP.

You buy gold, not because you specifically have negative interest rates.  You buy gold because there's no where else to put your money.  As a reserve currency country, your own negative interest rates is a requirement - but it isn't sufficient by itself to move gold.  This also has implications for PPs in smaller non-reserve countries.

Yeah I have never trusted non US PPs for those reasons. The gold component is not reacting relative to your smaller economy. If the environment changes where US isn't top dog from a currency standpoint I will probably make changes to my portfolio if possible.

If I could, I would probably hold 2 PPs for the two largest economies. Buying foreign bonds is basically impossible for me though.

[Gosso]

melveyr & Slotine,

I agree that gold is more concerned with the global economy, rather than each individual country, although of course the US takes up a large chunk of the pie.  But is there a reasonable compromise?  I think that for non-US PP's there should be at least half of the stocks placed into an ACWI, which is likely to play off gold much better than a concentration in a single countries stock market.

I personally like the following allocation for a non-US PP:

25% - LTT in local currency
25% - STT in local currency
10% - local stock market (protects against local economy outperforming global economy)
20% - All Cap World Index (gives you exposure to all major currencies and economies)
20% - Gold (plays off ACWI)

I quickly backtested this with Stingy Investor (Canadian figures) and found that the above composition reduced volatility from 8.6% down to 7.6%, while maintaining the same returns as the Canadian PP.

This is roughly what the Canadian Bogleheads recommend, except with more gold.

[Ad Orientem]

Gosso
That looks pretty reasonable to me. I have no real heartburn with going 30% equities and shaving 5% off gold if someone wants to go that route. And for non-US PPs I think they really need some global stock exposure.

[moda0306]

I agree persistent negative real interest rates are the primary driver of gold prices--not inflation rates.  Let's assume for a moment that the Fed had a directive to always keep real interest rates positive.  Would there be any strong incentive to purchase gold?  Probably not.  We had a period of positive real interest rates from 1980-2000 and interest in gold was nearly non-existent.

If you pull up the trade weighted dollar index and plot gold against it, the US negative interest rates and the spikes in gold don't entirely match up.  You would have expected more of a jump in 2002-2005.  But if you look against the euro, then it kinda makes sense why it was delayed until the end of 2005.  

I'm a bit concerned over the role of gold in the PP of late - especially as there are now more viable reserve currencies out there than just the eurodollar.  The 'fear' component no longer aligns with the contribution from the rest of the classic PP.

You buy gold, not because you specifically have negative interest rates.  You buy gold because there's no where else to put your money.  As a reserve currency country, your own negative interest rates is a requirement - but it isn't sufficient by itself to move gold.  This also has implications for PPs in smaller non-reserve countries.

Yeah I have never trusted non US PPs for those reasons. The gold component is not reacting relative to your smaller economy. If the environment changes where US isn't top dog from a currency standpoint I will probably make changes to my portfolio if possible.

If I could, I would probably hold 2 PPs for the two largest economies. Buying foreign bonds is basically impossible for me though.

melveyr,

You're leagues ahead of your years.  By "the two largest economies," do you mean us and China?

[melveyr]

If you pull up the trade weighted dollar index and plot gold against it, the US negative interest rates and the spikes in gold don't entirely match up.  You would have expected more of a jump in 2002-2005.  But if you look against the euro, then it kinda makes sense why it was delayed until the end of 2005.  

I'm a bit concerned over the role of gold in the PP of late - especially as there are now more viable reserve currencies out there than just the eurodollar.  The 'fear' component no longer aligns with the contribution from the rest of the classic PP.

You buy gold, not because you specifically have negative interest rates.  You buy gold because there's no where else to put your money.  As a reserve currency country, your own negative interest rates is a requirement - but it isn't sufficient by itself to move gold.  This also has implications for PPs in smaller non-reserve countries.

Yeah I have never trusted non US PPs for those reasons. The gold component is not reacting relative to your smaller economy. If the environment changes where US isn't top dog from a currency standpoint I will probably make changes to my portfolio if possible.

If I could, I would probably hold 2 PPs for the two largest economies. Buying foreign bonds is basically impossible for me though.

melveyr,

You're leagues ahead of your years.  By "the two largest economies," do you mean us and China?

Probably wouldn't go with China just because I am not sure how their bond market functions and I am not sure they are close enough to capitalism for me to fully trust as an investor.

Given the current economic rankings, I would likely have 3 PPs for the US, Japan, and the UK. I would weight the size of the PPs based off of the value of each countries government debt market (adjusting for exchange rates of course). Additionally, as I am sure you can appreciate, I would only do PPs in the countries with fully fiat currencies where the governments treasury is tied with their own central bank.

The only thing stopping me from doing this is a lack of money. I am sure implementing this would be a lot easier if I had millions of dollars