Gold's Correlation to Inflation

[TripleB]

I believe gold responds to anticipated inflation and not inflation itself. The inflation has not yet come yet gold has gone up substantially in response to anticipation of it, over the last 10 years.

Thus, when inflation does come, interest rates could rise, pushing LTTs down, and gold could fall, because the expected inflation did not meet the anticipated inflation that caused the runup in gold.

Gold does NOT match inflation in any sense. Gold has gone up 5x the last 10 years. The median US salary has not gone up 5x. I don't think it's even gone up 1.5x in the last 10 years.

Gas and food haven't gone up 5x in the last 10 years. Gas would be $12+ a gallon if gold matched inflation.

If it's true that gold responds to anticipated inflation, does that mean we need another asset class that does respond to inflation? If gold does respond to anticipated inflation, it would mean both gold and LTTs could drop next year if interest rates rise, but not rise to the point of anticipated inflation.

Is it possible that gold used to respond to inflation, but now with the internet, ETFs, and viral communication, gold has been responding in anticipation much more than actual? Perhaps gold is changing how it reacts in 2011 as compared to in the 80's when people had to physically go buy gold coins if they wanted to own it.

I don't dislike gold. I just don't think it will "work" as people may think it will. What if a person enters the PP today, and gold and LTTs drop in unison? Certainly they went up in unison over the last 3 years. It only makes sense that they may drop in unison as well.

I don't know of a "better" investing strategy than the PP and I'm sticking to it. Perhaps using the VP towards some things like commodities future that will react directly and immediately with inflation.

[AdamA]

If gold does respond to anticipated inflation, it would mean both gold and LTTs could drop next year if interest rates rise, but not rise to the point of anticipated inflation.

You mean if real interest rates remain low? 

Anything is possible, but generally speaking if real interest rates are lower than that of anticipated inflation, gold does okay. 

[TripleB]

If gold does respond to anticipated inflation, it would mean both gold and LTTs could drop next year if interest rates rise, but not rise to the point of anticipated inflation.

You mean if real interest rates remain low? 

Anything is possible, but generally speaking if real interest rates are lower than that of anticipated inflation, gold does okay. 

My impression:

Gold has been priced in for 6% compounded annual inflation going forward in perpetuity starting this year. If inflation is 3% then the price of gold drops because the actual inflation didn't hit the anticipated inflation.

Just like if Apple's earnings are expected to increase by X% and the stock rises y%, if Apple fails to meet those earnings next year, the stock will drop y% or more.

I believe that nominal interest rates will rise, as inflation stays about the same. Right now we have 0% interest rates and 3% inflation. I think next year we can have 2% interest rates and 3% inflation.

Gold is priced in at 6% inflation, so gold drops. Interest rates rise, so LTTs drop. Both drop together.

The 6% inflation that gold is anticipating is an estimate that I pulled out of my ass with no mathematical proof. I could take some time and develop a more accurate model. For example, suppose gold at $300/ounce in 2001 was pegged at 3% inflation. If gold rose with inflation, and if inflation has been 3% annualized over the last 10 years, then it would be about $400 per ounce today. However, gold is $1600 per ounce. That means the expected inflation in perpetuity is substantially more than 3%.

People might still anticipate 6% inflation starting next year, but every year it doesn't happen, the price of gold has to drop to meet reality, and the fact that there's one less year of higher inflation in the present value calculation.

Tangentially, I also feel as the gold market starts to drop a little, it could cause panic, and forced margin call liquidations that cause a huge decline.

I also imagine that if inflation rises for food costs, then countries that have been stockpiling gold recently will need to liquidate it for cash to pay for food for entitlement programs that all countries run. That could be downward pressure on gold, even as inflation hits.

Of course, this is all speculation, and that's why I'm sticking with the PP because 12 months from now gold could be at $3k per ounce, or it could be at $300 per ounce. No one knows.

[FarmerD]

TripleB,
You sound like me about a year ago.  I had a fear of possible impending inflation but didn't like it that gold had risen so much.  About the only assets I could think of that would respond favorably to rising inflation were:

A couple broad based commodity futures funds like PCRIX and USCI
Vanguard Energy fund
A diverisfied mining fund (vanguard PM and mining fund)
a junior miner ETF
buy some physical platinum
land

Eventually I came to realize if high inflation/hyperinflation (not likely but possible) occurred, only gold would respond in real time to increasing inflation.  And, of course, most of these other assets have had great runs too in the past 5-10 years just like gold so I'm not sure how much extra protection they would afford. 
 

[AdamA]

Gold has been priced in for 6% compounded annual inflation going forward in perpetuity starting this year. If inflation is 3% then the price of gold drops because the actual inflation didn't hit the anticipated inflation.

Where do you get 6%?

[KevinW]

I don't think the PP depends on the assets having a direct positive/negative correlation to their corresponding economic state.  The premise is that each economic state implies a rally in the corresponding asset.  In the case of gold, if inflation is happening then gold rallies.  Note that this does not necessarily mean that if gold rallies inflation must be happening.  (That would be affirming the consequent, a logical fallacy.)

There is no claim that a gold rally implies anything else.  Gold can rally for any number of reasons.  All the PP design requires is that, when (hyper)inflation is currently happening, the price of gold is going up.  2011 is consistent with the economy-implies-rally relationships; we had deflation which caused bonds to rally.  Meanwhile gold rallied due to confounding factors.

[clacy]

One way to look at it is Gold/STT are your protection during both negative and positive real interest rates.

LTT/Stocks are there to cover you for prosperity/deflation

[AdamA]

I don't think the PP depends on the assets having a direct positive/negative correlation to their corresponding economic state.  The premise is that each economic state implies a rally in the corresponding asset.  In the case of gold, if inflation is happening then gold rallies.  Note that this does not necessarily mean that if gold rallies inflation must be happening.  (That would be affirming the consequent, a logical fallacy.)

There is no claim that a gold rally implies anything else.  Gold can rally for any number of reasons.  All the PP design requires is that, when (hyper)inflation is currently happening, the price of gold is going up.  2011 is consistent with the economy-implies-rally relationships; we had deflation which caused bonds to rally.  Meanwhile gold rallied due to confounding factors.

I think that's nicely put.