What Can We Infer from $900 Gold?
Much is being written about gold these days as its price reaches record highs. Two of the most disconcerting things being written are: 1) that gold’s soaring price is a result of increased demand from overseas, and 2) that gold should be adjusted for inflation. These conventional ideas spawn from a basic misunderstanding of the yellow metal.
What must first be understood is that gold is a special commodity, unlike any other in the world. Gold has proven during the course of history to hold its value relative to other goods and services better than any other commodity. This is why, ages ago, when the dollar was held constant in gold terms, the price of bread cost the same in 1930 as it did in 1790. This critical attribute of gold, where it holds its relative value better than anything else known to man, is due to its unique physical characteristics. The world's total supply of gold is well known; gold is soft, and thus can easily be divided into different weights; portable; an efficient store of value because it can be easily hidden and transported; durable; and can be found all over the world.
The gold futures market is also unlike any other commodity futures market because it is the only one where the front month price is always lower than its future price. In traders’ speak, gold futures are always in contango and have NEVER backwardized. This means that supply and demand have very little, if any, effect on the price of gold. Conversely, other commodity futures markets backwardize during temporary spikes in demand or supply shortages. A recent example was the oil market after Hurricane Katrina when spot oil prices sky-rocketed higher than future prices due to supply shortages.
Because of gold's unique attributes, which are continuously validated by its futures market, the assertion that voracious demand from overseas has caused the dramatic rise in gold prices has no basis in fact. More realistically, the changes in the price of gold that we've witnessed are really a consequence of the changing value of the currency in which gold is denominated - not the changing value of gold itself.
As a result, the price rise in gold from $350 in 2003 to nearly $900 today indicates that the dollar has lost more than 60% of its value. In other words, where $1 bought you 1/350th of an ounce of gold in 2003; it now buys you 1/900th of an ounce. The dollar is truly buying less these days, and many consumers hit by rising fuel and food costs would agree.
Because gold holds its real value relative to goods and services, another way to think about this rise is to realize that the broad price level will have to increase to keep up with gold. Therefore, the 150% jump in the gold price means the cost of everything else in the price universe will eventually have to catch up if the dollar's fall is not corrected. Prices for commodities (such as oil and copper) usually adjust the fastest, while regulated prices (such as stamps) usually take the longest time. This price adjustment can take years or decades, and often times prices over and under-shoot because of the continued volatility of the dollar-gold price and the dislocations this causes for producers of these goods and services.
If one thinks about gold as an inflation indicator like this, it really becomes an inflation index. When gold rises X%, the broad price level of the economy (or inflation) will eventually increase by about that much; and vice-versa when gold falls. Therefore, indexing gold for CPI or other inflation statistics doesn't make sense. It's equivalent to adjusting an inflation measure for another inflation measure!
So during this period of record high gold prices, we should remember that gold is expensive because the dollar is weak and excessively abundant in supply. And furthermore, we shouldn't be adjusting gold for inflation, but instead should recognize that gold itself is an inflation indicator forecasting an incipient rise in the general price level of dollar-denominated goods and services.
