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BookmarkLast week the gold price jumped when markets heard that the ECB was cutting rates. But then Draghi spoke and when he did he alluded to the dreaded ‘D’ word, not deflation but disinflation.
What is it about disinflation that spooks the price of gold?
Disinflation disgusts gold
More often than not the terms deflation and disinflation are confused and used interchangeably. In fact when you google disinflation you are automatically shown results for deflation.
Disinflation is defined as a decrease in the inflation rate, i.e. a fall in the rate at which prices are increasing. Deflation is a fall in real prices. The former is often a precursor to the latter
As we know from the limitless rounds of QE, central bankers are terrified of deflation. So whilst deflation is the nemesis of the Bernankes of the world, disinflation is seen as its messenger boy sent with a warning that inflation will not be hanging around much longer.
Disinflation first appeared in the Eurozone in mid-2012 and its presence was no more obvious than in October when the inflation rate fell to 0.7%, its lowest in almost four years.
The topic of gold and disinflation is an area that was well covered recently by Ronald Stoeferle in his company, Incrementum’s In Gold We Trust report.
Ronald tells us that gold is a no go-er when disinflation is in our midst. In fact Ronni describes disinflation ‘as the worst possible environment for gold.’
Between 1974 and 1976 inflation rates were declining and it was during this time that we saw a correction in the gold price. Ronni points out that this period was ‘similar to the current one specifically on account of marked disinflation, rising real interest rates and extremely high pessimism regarding investment in gold’.
In the last 12 months the combined balance sheets of the Fed, the ECB, the Bank of England and Japan have been shrinking. This was spearheaded by the ECB and the Bank of England and was, in part, offset by the Fed and the Bank of Japan. In short the pace in the rate of inflation growth is declining, creating an environment that is unattractive for gold.
Gold, inflation and deflation
It seems that many commentators extrapolate from their knowledge of gold’s poor performance under disinflation that it should therefore carry through to deflation.
However Professor Roy Jastram, in the Golden Constant, demonstrated that gold in fact performed best in deflationary periods where it gained the most operational wealth and was a poor hedge against major inflation.
Modern research also shows this, with Ronald Stoeferle using regression analysis to show that the gold price tends to display a ‘nominally positive trend during periods of price deflation.’
Gold and inflation
Will things improve for gold should the central bankers get their way and inflate to stay afloat? The jury appears mixed on this. A standard list on why one should invest in gold will inevitably include its role as a hedge against inflation. Professor Roy Jastram’s The Golden Constant was seen as the first piece of statistical evidence that gold had acted as an inflation hedge since the sixteenth century.
The oft cited issue with Jastram’s analysis however is that it is now dated, the international monetary system has changed dramatically since 1977 when it was first published. This was just six years after gold was removed from sovereign currencies and too soon to see if its inflation hedge characteristics remained once it had been cut-loose from the dollar.
It makes sense that it was a poor hedge against inflation prior to 1971, a time when gold either was or was closely related to money. When prices rise the value of money falls.
We recently looked at some research carried out by Professor Brian Lucey and others. They reject the premise that gold and inflation are cointegrated, this is based on results that ‘show the sensitivity of the gold price to inflation declines in the 1990s.’ But it is important to note that in the 2000s ‘the comovement between these two factors increases significantly again.’
These findings are, I believe, in line with work carried out by the World Gold Council who updated Professor Roy Jastram’s work on gold and inflation and concluded that gold and inflation’s relationship has only become positively correlated in the last decade or so.
Is there anything to be learned?
But maybe we shouldn’t be looking at the value of sovereign currencies at all. Instead we should be looking at interest rates.
In the same Lucey et al. paper mentioned above the authors find that ‘gold’s inflation sensitivity, hence its role as a hedge, can be forecast by interest changes.’ Ronald Stoeferle agrees, and states that interest rates and the rate of change in inflation rates are what correlate with the gold price.
What’s the best worst case scenario
As we have looked at briefly above, inflation and deflation have both shown to be positive environments for gold. Disinflation is not. Is disinflation here to stay? It is unlikely, it has just as likely a chance as deflation of being allowed to play out – a very slim one. As we have seen in Draghi’s reaction, a central banker wishes to meet falling inflation rates head on with an inflationary overreaction.
Good news for gold.
