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Gold and inflation risk

The world is still struggling to manage and contain the coronavirus pandemic. As new strains flare-up, periodic lockdowns are reinstated, and the vaccine rollout surges and stalls depending on the country. Amid this uncertainty, there are signs of recovery. Economies have opened up, and businesses are trading again, scrambling to recoup losses and meet pent up demand. But this upsurge in demand, and supply shortages caused by the shutdowns, is pushing up prices. Inflation, dampened by low demand in 2020, is surging ahead again. How can you protect your assets from being eroded?

US inflationary pressure

The US inflation rate jumped to its highest level since 2008, rising to 5% in May according to the US Bureau of Labor Statistics, the latest in a steady uptick in inflation since January this year. Some of this increase was attributed to a rise in the price of second-hand cars (reflecting a shortage of new cars because of pandemic-induced supply chain issues), but the wider basket of goods has also been on the rise.

Is inflation inevitable?

Some level of inflation was inevitable. When people were stuck at home buying only essentials and unable to access many services, inflation was negligible. Prices were stagnant, and demand was low. As the economy has reopened, consumers can once again enjoy leisure services, shop in person, and catch up on curtailed spending. With demand surging, prices were always going to show a year-on-year rise, the concern is how long inflation will continue to rise and how high it will go.

Political intervention

Politicians and government economists are hopeful that inflationary pressure will be transitory as bottlenecks in supply ease and comparisons with last year’s slowdown fall away. Moreover, Federal Reserve chairman Jerome Powell doesn’t expect inflation to impact monetary policy, which has included ultra-low interest rates and billions of dollars worth of quantitative easing. But even if inflation isn’t worrying policy-makers, it is worrying people with assets to protect. According to a CNBC poll, two-thirds of wealthy investors are worried about inflation caused by recent government spending, and other asset advisors agree.

With gold denominated in dollars, the US inflation rate, interest rates, and currency rate will all impact the gold price, pushing and pulling depending on expectations and forecasts. Longer-term, though, gold has historically helped hedge against inflation, maintaining and growing in value through times of uncertainty as prices rise and spending power is crimped.

Worrying UK signs

The most recent UK inflation data showed that consumer prices rose 2.1% in May compared to the year-ago period. Even the Bank of England now expects inflation to rise to over 3% for ‘a temporary period’. This may not be as high as in the US, but the recovery is not as progressed, and the upward trend is similarly concerning.

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Historic lows may not last

Like elsewhere around the world, the UK has kept interest rates at historic lows and pumped money into the economy to try and stave off the worst effects of the global pandemic and lockdowns. However, with a successful vaccine rollout and re-energised business sector, some policy-makers are concerned enough about long-term inflation to curtail wasteful spending. Specifically, outgoing chief economist Andy Haldane has advocated for reducing the central bank’s bond-buying programme size. He cautioned earlier this month that this is the “most dangerous moment” for managing inflationary risk.

As expected, at the end of May the Bank of England Monetary Policy Committee voted to retain both the current interest rate of 0.1% and the rate of asset repurchases or quantitative easing. Most of the committee members believe quantitative easing should continue. Their expectation is for inflation to rise above the Bank’s target of 2% in the short term but to settle at or below that level in the medium term. The committee also said: “it is possible that near-term upward pressure on prices could prove somewhat larger than expected.”

Why should we worry about inflation?

Rising prices of goods and services reduce buying power. For example, according to the Bank of England inflation calculator, to replace goods costing £100 in 1920, you would need to spend over £4570 today, so £100 cash under the mattress in 1920 wouldn’t buy much in today’s money.

Wage erosion

When wages don’t rise in line with inflation, consumers get poorer. Of course, if wages are rising alongside inflation, it shouldn’t matter day-to-day how high prices go. But that is only true of immediate spending. The value of any savings or investments that don’t increase at the same rate will inevitably be eroded. And if wages don’t rise alongside inflation, then both current investments/cash and the buying power of any income will be eroded.

Inflation and the gold price

Historically gold has been seen as an inflation hedge, which is certainly true over the long term. For example, an ounce of gold was worth around $20 a century ago, and today it’s worth over $1780, keeping ahead of inflation over 100 years.

In the shorter term, as money supply expands (for example, during quantitative easing), more people demand the same goods, so prices rise. But when there is more money in circulation, it devalues the currency. So it takes more of the devalued currency to buy the same amount of gold, pushing up the price.

Gold hedge

For this reason, gold is often cited as an inflation hedge because it maintains its value even when inflation devalues the currency. Like interest rates, though, in practice, this link is not indelible. There are circumstances where other factors influence gold more than inflation, including market sentiment, monetary policy, currency fluctuations, geopolitical issues, supply and demand and price speculation.

Long term wealth assurance

Even if other factors move the gold dial over the short-term, gold as a long-term store of wealth is assured, and investors looking to avoid the corrosive properties of inflation will do well to consider long-term gold investments. The pandemic has flooded the global economy with uncertainty, but as inflation fears wax and wane, gold continues to thrive as an immutable physical store of wealth.

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