Gold price may signal future inflation, says study

There are growing concerns that big increases in money supply worldwide will put substantial upward pressure effect on inflation. A report published on Friday says the price of gold can be a leading indicator in this regard.

As money supply increases, the gold price rises, after a lag of about six months, according to the World Gold Council (WGC) study. Another WGC finding is that gold is an indicator of future velocity of money, in particular in the US. In other words, the gold price can be interpreted as a signal that the market expects the velocity of money to increase, thus raising future inflation.

Despite a large output gap around the world and anaemic economic recovery, says the report, investors are justified in their concern that quantitative easing resulting in rapid money-supply growth will eventually lead to an increase in the velocity of money and of inflation.

These could be significant points, given that there have been a number of forecasts that the gold price are likely to continue rising, potentially as high as $1,500 an ounce in the coming year. 

Gold is affected by many factors and in many markets, notes the report's author, WGC investment research manager Juan Carlos Artigas. Hence, concentrating purely on the US, for example, would mean missing the overall picture. Another point he makes is that the study's goal is not to present a forecasting model for the gold price, but rather to show empirically how gold and money supply relate.

A 1% change in US money-supply growth six months prior has an impact of 0.9% in the price of gold, on average. In addition, a 1% change in money supply in India and Europe six months prior, affects the price of gold by 0.7% and 0.5%, respectively. Money supply in Turkey has a small but significant impact on the future price of gold, adds WGC.

Money-supply growth in each individual country showed positive correlation to percentage changes in the price of gold, ranging from 0.1 to 0.35. This is something the report expected to see. Something it found more interesting, though, is that a six- to nine-month lag in money-supply growth increased the corresponding correlation to a range of 0.15 to 0.4 -- clear evidence, it says, that money-supply growth has an impact on future gold performance.

A further indication that the US economy should not be the only focus for the study was the level of demand for gold. From 2004 to 2008, 11% of global demand, including jewellery, investment and industrial applications came from the US. Moreover, over the past five years, 68% of average annual demand has come from jewellery, with more than 50% of this demand stemming from India, China, Turkey and the Middle East. Investment demand, on average, accounts for 20%, where India, Europe and the US play an eminent role. The remaining 12% average comes from industrial demand, especially from Japan.

As for monetary-easing measures, not all investors agree on the extent that these will have on the magnitude and timing of future inflation. "Nevertheless," says the report, "what cannot be denied is that more money is in the system, peace time deficits will soon hit new record highs as a proportion of GDP, and that alone is a strong enough argument for many to flock to hard assets."

The WGC also found that gold is an indicator of future velocity of money, in particular in the US. A 10% increase in the price of gold tends to increase the velocity of money in the US by about 0.4% in 12 months' time, says the report. In other words, the present price of gold is a signal that the market is expecting velocity to pick up in a year, on average. The report adds the caveat that "the explanatory power of the model is small, as a single country (the US) is used".