DO GOLD PRICES REALLY REFLECT INFLATION?
From time to time, gold bugs come out of the closet and harp on the fact that we are not on the gold standard, or that policymakers are not paying sufficient attention to sharp rises or declines in gold prices. Supposedly, Fed officials monitor movements in gold prices, although it is unlikely that they worry about every dip and wiggle. Over the long haul, it is true that gold prices and the inflation rate tend to move in the same general direction. When gold prices spurted in 1979, the U.S. rate of inflation was surging at double-digit rates. And when inflation dropped back, so did gold prices. However, if one looks closely, one can see that not every movement in inflation is mirrored by a similar movement in gold prices. From time to time, these two move in opposite directions.
Over time, gold prices might move in tandem with inflation patterns, but unlike other investments such as housing or stocks, gold prices in fact have not kept up with inflation. In nominal, or current dollars, gold prices in January 2006 were at their highest level since January 1981! Wow, to reach levels last seen 25 years ago seems amazing. But then consider the value of gold prices, adjusted for inflation. We deflated gold prices by the consumer price index. It is certainly appropriate to use the total CPI rather than the core (excluding food and energy prices) because food and energy account for more than one-quarter of consumers' purchases each and every year. Over the long run, one must consider the total purchasing power of our dollar. After adjusting for inflation, gold prices have indeed increased from their lows in recent months, but at $276/ounce, real gold prices are still lower than they were 15 years ago (January 1991).
Gold prices may suggest inflationary pressures at moments in time, but over the long haul, gold prices have not kept up with inflation. Real (inflation-adjusted) gold prices are just now coming back to levels seen 15 years ago. We've all seen commercials touting gold as a valuable investment, but don't let the gold coins entice you. Gold jewelry may glitter, but gold investments haven't for the average investor. Times might change however.
Gold (commodity) traders in London are hoping that Chinese demand for gold jewelry will match India's demand, although many are skeptical that demand will skyrocket any time soon. Until 1982, Chinese individuals were not allowed to own gold, but China has deregulated the gold market in recent years. Moreover, the Shanghai Gold Exchange was founded in 2003 so that professional investors could trade in gold. Global gold investors, however, should not count on the Chinese to boost gold prices though, since gold production in China could meet its own demand and some export demand as well in upcoming years.
In London, professional commodity traders believe that gold-backed Exchange Traded Funds are currently playing a role in fueling gold demand - and thereby boosting prices. While pension and mutual funds are not allowed to directly own commodity assets or futures, they are allowed to trade ETFs. This means that demand for commodity funds may increase.
BOTTOM LINE
Be cautious in the commodity market. Speculation might be profitable in the short run, but over the past 25 years, it is hard to believe that holders of gold bullion made much money. Just look at the charts!
Evelina M. Tainer, Chief Economist, Econoday
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