How has inflation impacted the price of gold?

Gold: A safe haven during accelerated inflation?

We’re only half way through 2022 yet, already a record amount of physical gold, gold exchange-traded funds and other exchange-traded products have been purchased by investors this year. This caused the gold price to rise to near all-time highs of over £1500 an ounce this March, a level not seen since August 2020, during the height of the COVID-19 pandemic. There is no doubt why. Looking back to the start of the pandemic, gold was a strong performer throughout 2020 and it had the highest return of any major asset class, returning close to a 25% yield.

However, 2022 will be a different year. Despite gold’s strong recovery from its 13% dip in 2021, unprecedented global factors still pose significant risks to the economy. The sluggish recovery from COVID-19, Brexit ramifications and now the European energy crisis from the conflict in Ukraine mean that uncertainty is rife. Now, mid 2022 as the UK government collapses, investors are still facing down inflation as one of the biggest risks to their savings. Is gold once again the safe harbour to ride out the financial storm?

How has gold performed historically during times of high inflation?

Gold’s performance over the past 50 years tends to support the theory that gold is a hedge when inflation is significantly higher than any target set by Westminster.

According to a study by the World Gold Council, over the last half a century, gold has returned 15% per annum on average when inflation is higher than 3%, compared to just over 6% per annum when inflation is lower than 3%.

How does inflation impact the economy?

Enter May 2022. Consumer inflation reached its highest level in more than four decades due to rising fuel prices and food costs. Pressures resulting from inflation have a wide range of economic ramifications. Increasing the cost of retail goods and services, inflation first reduces purchasing power.

Due to increased risk, borrowing costs may also increase as interest rates rise. Furthermore, inflationary pressures can fuel further inflation, resulting in a feedback loop.

As people spend faster in order to reduce the amount of time they spend holding depreciating currency, the supply of money exceeds the demand, causing the currency’s purchasing power to fall even further.

In a nutshell, money buys fewer goods and services, decreasing the incentives to save cash and encouraging diversification into other assets or instant spending.

Assets, however, can retain their value more easily. Cars (which have seen 28% increase in prices this year according to Autotrader), houses at 12%, and gold with 20% increases from June 2021 to 2022. In the chart below the last few crises are apparent, 2008 subprime mortgage disaster and more recently 2019-2022 with the triple whammy of Brexit, Covid and Ukraine.

Gold Price per Oz (£) vs UK Inflation (%) 2002-2022

Why does inflation increase gold prices?

Inflation increases the price of consumer goods, resulting in the pound losing value. As inflation rises, the price of gold denominated in pounds increases.

Because investors convert their cash holdings into gold to protect their assets against inflation, gold is a good hedge against inflation. It is possible that an increase in investor interest will lead to a bull market in gold until the inflation effect subsides.

Our previous articles have discussed the advantages of gold as an investment and its importance as a means of protection from inflation. Creating more fiat currency lowers the value of each pound in circulation when inflation occurs.

Gold prices during the 2007 financial crisis

Taking a step back just a few years more, we can see how gold reacts to another financial crisis. In our chart we see a steep increase in the price of gold during the financial crisis that was arguably started with the failure of a variety of investment banking firms from March 2008. Over the course of this period, gold prices first rose, then fell by about 25% during the first few months. Prices then went on to regain all losses within a short period of time and rally to historic highs. Short term the market was very volatile, longer term for anyone holding gold from that time it was a great investment that outperformed other assets.

What makes gold a safe hedge vs inflation?

There is a good reason for the reputation of gold as a hedge against inflation. Since fiat money (paper money) decreases in value during times of inflation, people turn to the assets that have been used as money throughout history – gold and silver. Among the former metals, gold has the reputation of being the ultimate inflation-hedge (silver is regarded as a primarily industrial metal today).

Therefore, inflation and the gold price exhibit a strong positive relationship. As seen throughout the last 25 years in the gold and inflation chart above, gold rallies when inflation rises. An increase in the money supply leads to an increase in the price of goods and gold is a liquid asset.