Basic Economics: Inflation’s Effects on Gold Prices
Gold investment levels in Asia continue to hold close to their all-time highs, and many regional investors are asking questions about what is next for the bullish trend in precious metals. To answer this question, it is important to take another look at old-fashioned economics as a means for determining how price valuations are likely to unfold in the future. One of the most critical economic forces in these areas is the force of market inflation, and its influence on the yellow metal can be significant depending on the underlying fundamentals present in the global economy.
What Causes Global Inflation?
Inflation -- or, in other words, devaluation -- of world currencies has been a hot topic for years. The threat originated back in the 1970s when the United States abandoned the Gold Standard. With interest rates remaining so low for so long the risk of currency inflation has grown immensely. What exactly causes inflation, and how does inflation affect gold prices? This article will briefly answer those questions.
There are two main causes of inflation. The first cause is classified as “cost push inflation.” This type of inflation causes the dollar to lose value due to the fact that companies have to pay more for things so they pass those costs onto consumers, thus making products more expensive. The second type of inflation is known as “demand pull inflation.” Demand pull inflation happens when manufacturers reach the maximum amount of production of goods and services in spite of exploding demand. When short- term economic growth surpasses the average economic growth rate then demand pull inflation occurs.
How Does Inflation Affect Gold Prices?
Inflation has an immense effect on gold prices. The first effect has to do with inflation itself. When more fiat currency gets created, it lowers the value of every other dollar in circulation. Gold and other commodities that are priced internationally in US dollars automatically cost more because you’ll need more of the newly-devalued dollars to purchase the same amount of gold (whose inherent value hasn’t changed in thousands of years.
The second effect that inflation has on gold prices involves market sentiment and speculation. News junkies are probably aware that each time the Federal Reserve mentions interest rate hikes, gold prices jump. If there is speculation that certain central banks or governments are stockpiling gold to combat inflation, gold prices will almost inevitably increase. If you’re an inflation “hawk” then you are well aware how important inflation and inflation-related news is to gold prices.
Conclusion
Clearly, inflation has a direct effect on the price of gold. If you think that inflation will only worsen in the coming years then a gold investment might be something worthwhile for you to research. If you don’t see a problem with the U.S. Dollar Index’s trend then you might not feel a need to own gold. Undoubtedly, however, the level of inflation to the U.S. Dollar has an immediate and severe effect on the price of gold and other precious metals (not to mention other commodities).
This column was written by Richard Cox, university teacher in international trade and finance, focusing on lessons in macroeconomics and price behavior in equity markets.