Gold Also Glitters During Deflations

Empirical evidence shows that this proven inflationary hedge helps portfolios during any kind of price instability.

The evidence for gold as an inflationary hedge is overwhelming, while information on gold's performance during deflationary periods has been relatively hard to come by. But if gold should only be held during inflationary periods, then investors are left with an apparent market timing problem.

This is not a purely academic interest. It raises real problems in managing portfolios. All of the best available research argues that market timing is an exercise in futility. In test after test, over the long haul, buy-and-hold strategies create higher returns. Fortunately, according to our research presented here, trying to time inflationary and deflationary cycles to make gold purchases and sales is unnecessary. Gold performs well in both environments.

Currently, we are at an unusual juncture in the US economic outlook in which this is useful information. Some economists, looking at the record growth in bank reserves, are predicting much higher rates of inflation in the years to come. Others point to the European crisis and likely recession, the Chinese slowdown, and sluggish growth and deficit issues domestically as the reason they believe we are headed for another recession and a serious bout of deflation. (We don't.)

Measurements of price level changes - inflation and deflation - have gone through dramatic changes over the decades and centuries. In colonial times, little consumer expenditure was for services, and much of it was for raw materials to make things at home. In addition, in the past, simple or geometric averages were all that was possible.

Today, indexes are heavily weighted toward service prices, and people mostly buy manufactured goods. Index construction methodologies are very sophisticated because we know how to weight price components to form more representative estimates of price impact on economic activity.

This study looks at the American experience from 1790 to the present. The price measurement data is the Wholesale Price Index. This index is one of the oldest time series compiled by the US government constructed on a consistent basis. It was created to satisfy an 1891 US Senate Resolution. The index was extended to the colonial period as part of a special compendium of data that was assembled by the US Department of Commerce in honor of the US Bicentennial in 1976. It was re-named the Producer Price Index (PPI) in 1978.

The PPI measures intermediate or wholesale goods prices. The prices of these goods are more volatile than consumer prices. They also do not exhibit the same long-term rising trend as consumer prices because of the increasing importance of services.

This study also examines the economy of the United Kingdom from 1560 to 1974. Although UK and US histories are closely related, there are pronounced differences in the timing and magnitude of recessions and inflation cycles. In addition, exchange rate changes led to different gold price patterns.

Loosely speaking, deflation is a period of declining prices and is different from disinflation, which is a period of falling inflation rates. But there is no arbiter of the minimum magnitude and duration necessary to declare that deflation has occurred.

This study defines deflationary episodes by looking at periods during which producer prices declined by one standard deviation or more for one year or more. In the US, a decrease in prices at the producer level, which exceeds one standard deviation, is a decrease in prices of more than 7%.

Purchasing power is the best way to summarize the net result of two price movements: the price of gold and the inflation rate. To calculate this correctly is not a simple matter of subtracting the two rates. The calculation is to divide one plus the percentage change in gold by one plus the percentage change in the inflation rate and subtract one from the result.

According to this definition, there were only 12 deflationary events in the US during the 221 years examined. Eight of these occurred in the 19th century. There was one in the late 18th century, only two in the 20th century, and one so far this century.

The data reveal a dramatic shift, starting around 1949, in inflation/deflation trends and patterns. From 1790-1949, the annual inflation rate averaged barely 1%, yet there was high volatility of nearly 10% around that trend. From 1950 to present, the inflation rate has more than tripled, averaging 3.4% annually, but with half as much volatility at 4.6%.

The shift to higher inflation with less volatility suggests a revision in the identification of deflation events. Instead of a -7% hurdle, it suggests that a -9% hurdle be used prior to 1949, and a -1.2% hurdle be used in more recent times.

This leads to the addition of three more deflation events, all in the post-World War II era. All 15 deflationary events are shown in Chart 1, A and B. Chart 1A shows the history of gold prices and producer prices in the US from 1790 to 1970. This takes us from the early days of the nation until the closing of the gold window in the Nixon administration, which led to the end of the post-WWII gold exchange standard. Chart 1B takes us from that time forward.

The light blue shading shows deflationary periods. On average, across the 15 deflationary events, the purchasing power of gold increased by 31%. The average deflation lasted about five years. This implies a simple annual average gain in purchasing power of about 6% from holding gold
during deflations.

Gold did not appreciate in value during these periods. In some cases, it even declined. But with the exception of 1996-98, cumulative deflation was greater than the decrease in the price of gold.

The unusual events of 1996-98 warrant more careful analysis. Gold's purchasing power plunged by 24%, using annual data, while producer prices declined by 2.6%.

If we look at monthly data for this episode, the exact period of deflation was from January 1997 to February 1999. During this period, producer prices declined by 5.7% and gold prices declined by 19.1%. Consumer prices, on the other hand, rose by 3.3%. Much of the difference was because of the collapse in oil prices. During this period, crude oil prices fell by 52% from $25.17 to $12.01 per barrel.

As Chart 2 shows, since the 1973-74 recession, there has been a measurable increase in the correlation between oil and gold prices. Both have risen. If the fortunes of oil producers are somehow related to major moves in gold prices, then the large decline in gold prices during 1996-98 may be more related to the collapse in oil prices than to the extent of deflation.

The data for examining deflation in the UK goes back a lot further than is the case for the US thanks to Dr. Roy Jastrom's seminal work, The Golden Constant, first published in 1967. Jastrom assembled gold price data from the records of the longest continuously operating gold merchants, Mocatta Goldschmid, and constructed an inflation index based on data for commodities and manufactured goods collected from a wide variety of sources. The index goes covers 416 years.

Jastrom identified 20 deflationary episodes during this period. Once again a deflationary event was defined as one during which prices declined by more than one standard deviation of historical price variability. In the case of the UK, this was 8.3% - quite similar to the US.

Chart 3 shows the results of his study. On average, deflations lasted 6.6 years, and prices fell 22%. During the episodes, gold prices rarely declined and in a few cases increased. On average, the gold price changed by a mere 0.6%. As a consequence, the purchasing power of gold increased on average by 36% during deflationary periods. There were no instances in which gold prices declined by more than the price level.

Overall, these results were similar to those of the US.

The empirical evidence from both the US and the UK is clear. Gold is a store of value even during deflations. The purchasing power of gold rises because it does not go down in value to the same extent the price level declines.

Gold works as a hedge against deflation as well as against inflation. In a portfolio, it can provide insurance against any kind of price instability.

Gregg Van Kipnis is chairman of the board of American Investment Services, a wholly owned subsidiary of the American Institute for Economic Research, which has conducted independent, scientific, economic research since 1933.

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