Gold as a Hedge Against Inflation

Inflation is a measure of how much prices increase over time. Due to inflation, goods and services become more expensive, which means they cost more money to buy. Hence, inflation is also an inverse measure of money, or more accurately – purchasing power. The higher inflation goes, the more expensive things become. You need to spend more to afford the same things as before. 

Everyone, not just investors, are negatively impacted by inflation, especially when it grows at a high rate. However, savvy investors who understand that inflation erodes buying power can take steps to minimise the ill effects of inflation. 

One way is to invest in gold to hedge against inflation and preserve the buying power of your money.  

This is possible because the value of gold has been seen to hold up well against inflation, in comparison to money. The commodity is capable of producing returns that are higher than inflation, thereby preserving purchasing power. 

In fact, during the past five years, gold has even outperformed the S&P 500 – growing 81.65% vs the index’s 76.22% – making the commodity an even better inflation hedge than equities during this period ^[1].

Yet, there have also been periods when gold underperformed, producing negative returns. So what does this mean for gold’s reputation as an inflation hedge? And can investors continue to rely on the precious metal to hedge against inflation?

Key Points

• Gold has historically been seen as a reliable hedge against inflation, often outperforming other asset classes during periods of high inflation.

• Despite its reputation, gold’s performance as an inflation hedge can be inconsistent, as shown by periods of underperformance compared to other investments.

• Central banks have significantly increased their gold purchases in recent years, highlighting its continued importance as a store of value globally.

Why is Inflation a Concern?

It’s important to understand that inflation has a wide-ranging impact that affects all participants of the financial system. When prices rise in one portion of the supply chain, its effects are felt downstream by consumers. Because consumer spending is what drives the economy, high inflation can interfere with economic growth, causing it to slow down or even reverse, leading to a recession. 

In general, the negative effects of inflation can be broken down into three areas. 

Inflation Reduces Purchasing Power

As mentioned in the opening of this article, as inflation goes up, purchasing power goes down. 

This is because as prices increase, you have to pay more for the goods and services you need. Assuming your income remains the same, this leaves you with less money to pay for non-essentials like dining out, shopping or going to the movies. 

And when you do spend on non-essentials, higher prices means you won’t be able to purchase as much as before (for example, no more popcorn and drinks at the movies, only the tickets, or going out to eat twice a month instead of weekly). 

By making things more expensive, inflation reduces your purchasing power, unless your income also increases to make up for the higher prices. 

Inflation causes Loss of Goods and Services

Inflation-driven reduction in purchasing power can lead to loss of goods and services. In dire cases, inflation can render essentials such as utilities and housing unaffordable.

For instance, a surge in home rents in the U.S., has led to record levels of homelessness across the country in 2023 ^[2]. Renters have also been forced to switch to smaller homes or move back in with parents. 

In the wake of the COVID-19 pandemic, a shortage in global oil supply caused the price of energy to spike, leaving millions in the UK facing poverty due to sky-high energy bills. This led to a civil disobedience movement among afflicted consumers who could no longer afford to pay their bills ^[3].

Inflation Leads to Less Savings

Another negative effect of inflation is that it can lead to less savings. This is because when consumers have to spend a greater portion of their paycheck on rent, utilities, food and other essential expenses, there is less leftover at the end of the month to put into savings. 

Some may even find themselves unable to save anything at all, severely disrupting future financial goals. 

How Does Inflation Affect Gold Prices?

If inflation drives up prices, leaving consumers with less money to spend, how does this affect the price of gold?

Interestingly, during high inflation, investors have shown a preference for investing in gold, leading to rallies in gold prices. This behaviour is driven by gold’s reputation of being an inflation hedge and ability to preserve purchasing power. 

As such, investors buy more gold when inflation is high to garner a better return on their money, instead of simply letting their cash erode in value. Furthermore, the increased demand helps to drive up gold prices, further strengthening gold’s status as an inflation hedge.

This reputation isn’t undeserved. For instance, in 2022, gold demand soared by 18% to 4,741 tonnes, nearly matching the levels of 2011, bolstered by a record fourth-quarter demand of 1,337 tonnes ^[4].

Gold’s Track Record as an Inflation Hedge ^[5]

Gold is in no way a surefire winner during high inflation, as a survey of its historical performance will reveal. 

Perhaps the clearest demonstration of gold’s inflation-hedging ability was seen in the 1970s. Between 1973 and 1979, oil price shocks and energy shortage spiked U.S. average annual inflation to 8.8%. 

During those six years, gold prices mounted a strong rally, producing an impressive 35% annual return. Such an outstanding performance no doubt cemented gold’s status as an inflation hedge in the minds of many. 

However, in the following decade, gold faltered. 

Between 1980 and 1984, annual inflation in the U.S. averaged around 6.5%; gold fell by an average of 10% per year. This decline meant that gold also underperformed other popular asset classes, including the S&P 500, commodities and real estate. 

A few years later, this dismal showing repeated itself. Between 1988 to 1991, inflation was still high at around 4.6% per annum. Gold, however, continued to fall by 7.6% per year on average. 

The lesson here is that while gold has had its moments of brilliance, there were also occasions where it failed to live up to expectations. As such, investors should bear in mind that while gold has the potential to convincingly hedge against inflation, it is not a perfect solution. This also tells us that gold price is likely influenced by several other macroeconomic factors, and not simply inflation. 

Gold as an Inflation Hedge Today 

In the recent few years, gold has once again captured the spotlight with strong price performance. Since the end of the COVID-19 pandemic, gold has rallied strongly as the stock markets began a new bull cycle. 

See the following chart, which details the price of gold/oz from 3 October 2022 to July 2024 (the time of writing this article). 

During this period, the price of the precious metal has risen from US$1,668.40 per oz to US$2,406.85 per oz. That’s a total increase of over 44%.

One reason for this price spike is increased demand, notably from central banks around the world. Starting in 2021, central banks increased their buying of gold by 82%, lifting the global total demand to a near 30-year high ^[6].

This was followed by a new record in 2022, when central banks increased their gold buying by 152% year-on-year, absorbing a total of 1,135.7t of the precious metal ^[7]. Gold demand remained strong in 2023, with central banks continuing their buying spree, totalling 1,037.4t ^[8].

And in 2024, central banks are continuing to buy up gold, absorbing 290t in Q1 – the strongest start to any year on record ^[9].

Led by continued central bank demand, gold has emerged as one of the top performing global assets in 2024. This strong performance is set to continue throughout the year, with 29% of central banks polled indicating they would continue to increase their stockpiles of gold ^[10]. 

Interested in understanding gold price trends? Explore our article ‘Gold Price Over 10 Years and Gold Trend Analysis‘ to gain insightful analysis and learn more about the dynamics of gold prices over the past decade.

Taking a Leaf from Central Banks 

This strong demand from central banks is a potent reminder of the staying power of gold – that it is still a universally recognised store of value that is as good as, if not better than, fiat currency. 

Thus, while the gold market has its moments of volatility, and the commodity has had bouts of underperformance, gold remains strongly entrenched as a foremost asset class. Given that gold is rare, scarce and valued in all market conditions, the shiny yellow metal is unlikely to go out of fashion, whether as a medium of exchange, an investment asset – or even as a hedge against inflation.

Yes, gold’s track record in this area renders it an unreliable option at best. But despite that, gold can still offer value to investors, given its historically low correlation to equities and bonds. 

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