Gold and inflation

08Dec05

The rise of gold from some $250 an ounce in 2000 to over $500 an ounce in 2005 has set off another wave of interest in the shiny metal. The challenge for novice investors is to sort the mythology of gold from the cold-hard facts of its investment value. Two recent articles take a rational look at the current state of the gold market.

James Hamilton at Econobrowser notes that since 1970 gold has not been a particularly good proxy for consumer inflation. In addition he draws the distinction between this commodity and income generating assets like real estate and TIPs. If an investor has a firm belief in unexpectedly higher inflation then,

..if you did want to bet on inflation, there are better vehicles out there for doing so, such as going short 10-year bonds and long on inflation-indexed securities.

The gold bugs are never at a loss for reasons why the metal should be a significantly higher prices. However in an article by Michael R. Sesit in the Wall Street Journal there may be much more mundane reasons for the recent run in gold.

“The recent increase in the price of gold can be attributed to growing demand in a market in which supply has not increased nearly enough,” says Adam Tejpaul, head of commodities at J.P. Morgan Private Bank, adding that “the increase in wages in China has brought a new consumer to the jewelry market.” He also cites the reduction in central-bank sales of gold reserves, which limits the supply of gold coming to market and investor worries about inflation

Indeed the run up in gold may simply be a part of a much wider phenomenon.

Richard Cookson, a strategist at HSBC, contends that much of the purported case for gold is delusional. Apart from the 1970s and early 1980s when gold offered an antidote to galloping inflation, “there is almost no link between gold and inflation,” he says. “Why would you ascribe a special wisdom to the gold market when far more liquid and deeper markets, such as bonds, give you much more accurate information?”

Noting that easy credit has driven the price of junk bonds, emerging-markets, property, oil and even Saudi Arabian falcons to “silly levels,” Mr. Cookson says, “Arguably, the rise in the gold price has been driven by the same forces that have been driving everything up.”

Gold could very well continue going rising in 2006 and beyond. If it does, it won’t be because it has any special properties. The law and supply and demand still stands in good stead.




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