GOLD — Deflation Hedge? (November 20, 2008)
Gold’s relative price strength in recent days — in the face of plummeting U.S. consumer and producer prices, declining prices for oil and other (non-precious metals) commodities, and lower multi-year lows in world equity markets — suggests that the yellow metal, technically speaking, may be building a solid base in the $770 to $800 range from which to embark on a sustainable advance into higher territory.
Interestingly, gold has been outperforming silver and the PGMs, suggesting that investors and traders are differentiating among the metals, favoring gold as a monetary asset, safe haven, and hedge.
Deflation in the Air
With all the talk suddenly about deflation, gold- and silver-market participants need to know just what effect deflation might have on these precious metals.
Deflation is a persistent ongoing month-after-month reduction in the general price level, usually characterized not only by falling prices for goods and services but falling prices for most commodities, real estate, equities, and other assets.
Deflation is caused by declining demand for most goods and services and an unwillingness on the part of consumers to spend. And, absent spending from households, industrial capacity utilization shrinks and business capital investment grinds down.
In anticipation of declining prices, consumers and businesses have an incentive to postpone purchases which, in turn, further reduces overall economic activity, employment, personal incomes, and the general level of demand across the economy. And, with falling demand comes still lower prices across the board — in short, a deflationary spiral.
Most people who think about these things assume that gold prices must fall during periods of deflation. After all, deflation is the opposite of inflation — and since gold rises during periods of inflation, shouldn’t it fall during periods of deflation?
But, paradoxically, gold is both an inflation hedge and a deflation hedge. And, it is least attractive during periods of relative price stability.
Here’s why gold is a deflation hedge:
During periods of deflation, when spending shrinks and savings (in anticipation of lower consumer prices) rise, households hoard cash and cash-equivalents such as short-term U.S. Treasury debt, bank deposits, and money-market instruments. Gold and silver are also a cash equivalents and some will choose to hold more of their savings in these metals, particularly during times of stress and economic uncertainty when gold just feels safer.
Moreover, deflations are also characterized by very low interest rates, both in nominal and real (inflation-adjusted) terms. Why? Because the demand for credit is very low (no one wants to borrow and, if they do want to borrow, the banks are loathe to lend), savings are high, and — importantly — the Fed and other central banks will push rates down to encourage economic recovery. So the opportunity cost of holding gold and silver (the interest forgone by holding these metals rather than an interest-bearing asset) is extremely low, further encouraging some investors to favor the metals (because of gold and silver’s other attractions and attributes) over alternatives.
I’ll have more to say about the prospects for deflation versus inflation — and the implications for gold and silver — in forthcoming posts.
