Gold Not Oil Inflation (3)

8/2/2019 Gold Not Oil Inflation (3)

1/8

We are now into a second year of

extreme volatility in the price of oil.

Although the economy so far is weather-

ing it well, investors are scrambling to

adjust their portfolios. Will prices stabi-

lize, fall back, or escalate further? When

the volatility ends, we expect them to

decline, but only very slowly.2

But how much does the price of oil mat-

ter? Our research indicates that there is

not much point in formulating broad

investment strategy based on what oil is

likely to do in the futureor even on what

it has done in the recent past. Even if we

knew for sure at what level oil prices will

stabilize, the economic consequences

would not be predictable. Far more sig-nificant for the future of inflation and the

economy as a whole is the price of gold.3

A large increase in energy prices

undoubtedly reshuffles resources among

sectors within the economy; but history

refutes the oft-repeated claims that a

recession necessarily follows or that

inflation must accelerate. Three limiting

factors apply:

changes in the dollar-price of oil, to a

large extent, have historically been a

reaction to changes in the dollars pur-

chasing power;

a rise in the price of one commodity

(however important) relative to other

commodities is not in itself sufficient to

force a rise in the general cost of living;

the number of episodes in which the

price of oil changed substantially in a

short period has been too few to serve

as a basis for accurate forecasts.

This paper demonstrates the extent to

which the prices of commodities such as

oil and gold serve as leading indicatorsof unanticipated inflation and interest

rates. The evidence presented covers

producer prices, consumer prices and

bond yields in the United States, but

other work suggests that the relation-

ships found are not greatly different in

other currency zones, in some of which

central banks have adopted inflation tar-

gets that are much more explicit than in

the U.S. We believe it will be of substan-

tial interest to investors to know that gold

is a superior (perhaps the best available)

early warning indicator of inflation. Ways in

which investment performance can ben-

efit from taking advantage of the proper-

ties of gold and other commodities will

be presented in forthcoming papers.

Gold versus oil as a leading

indicator of inflation.

There are several ways in which the gold

market provides more accurate informa-

tion about future economic and capital-

market performance than data from theoil market. Figure One shows, for exam-

ple, that when the price of gold rises, pro-

ducer-price inflation tends to accelerate

in the following year; when the price of

gold falls, it tends to decelerate.

Although the data presented in Figure One

go back to 1951, there is a break in

1

N O V E M B E R 2 0 0 5

gold:report

Why gold, not oil, is the

superior predictor of inflationBy David Ranson, H. C. Wainwright & Co. Economics1

1 For more information about the author, please see p. 6-7. Please read the disclaimer on p. 8

2 See Energy is too high-priced to be a good strategic bet, Strategic Asset Selector, H. C. Wainwright & Co., Economics Inc., March 2005, forthcoming.3 This report updates earlier work by Wainwright in which we analyzed the powers of gold as an inflation indicator. See Watch gold, not oil, Economic and

Investment Observations, Wainwright, September 19, 1990; and Richard M. Salsman, What explains golds forecasting power, Wainwright, April 1994.


2/8

behavior around 1968, prior to which the

Bretton Woods monetary system was in

force throughout the world, and the price of

gold in terms of the dollar varied very little

around its official target of $35 per ounce.

By the same test, oil is a relatively poor

performer as a leading indicator of infla-

tion; in fact the oil price has been little

better than random. As shown in Table 1,

the correlation between movements in

producer prices and oil prices in the prior

year is almost zero.4

The results in the table are reinforced

when we combine price data for both

gold and oil in a single least-squares

equation to anticipate movements in

either producer- or consumer-price infla-

tion. Only the gold variable is statistically

significant. Thus for purposes of antici-

pating inflation one year in the future,

there is no significant information in the

price of oil that is not already captured by

the price of gold.

Why do oil prices serve so poorly as a

leading indicator of inflation? It is true

that a rise in the cost of energy will tend

to drive up the prices of goods in the pro-

duction of which energy is required. But

no single commodity can drive up the

prices ofallcommodities. Only the feder-

al government, by allowing the value of

the currency to depreciate, can do that.

To create a rise in the general price level

requires more than an increase in therel-

ative price of a particular group of com-

modities. Indeed, an energy-price

increase is inherently deflationary. By

absorbing a larger slice of the incomes of

energy users, it makes most other com-

modities less affordable.

Gold versus oil as a leading

indicator of the bond market.

Precisely because it anticipates inflation

so well, gold is also a powerful predictor

of nominal interest rates, both long and

short. This, in fact, is a more rigorous test

of the relative powers of gold and oil,

because bond market performance is an

objective indicator, and is free from many

of the errors of measurement that bedev-

il the official indices of inflation. In similar

research on short-term interest rates we

have obtained very similar results.

Our calculations show that the time

frame that yields the optimum correlation

gold:report www.gold.org

2N O V E M B E R 2 0 0 5

4 These correlation coefficients are obtained from regression equations (based on annual data) in which the dependent variable is the rate of inflation one year in

the future and the explanatory variable is the change in the price of the indicated commodity.

Figure Two: The Bond Market Follows Gold, Not Oil

Data: As for Table 1, together with calendar-year averages of daily ten-year

Treasury bond yields (Federal Reserve Board).

Table 1: Correlations between Inflation Rates and Oil and Gold

From 1951

Commodity Producer-price inflation Consumer-price inflation

indicator one year later one year later

Gold .37 .50Oil .01 .23

Data: Calendar-year averages of monthly indices for producer prices (all commodities) and consumer

prices (all urban consumers) and of daily prices for gold bullion and Brent crude oil (Wall Street Journal).Data:

Calendar-year averages of monthly indices for producer prices (all commodities) and consumer prices (all

urban consumers) and of daily prices for gold bullion and Brent crude oil (Wall Street Journal).

-3

-2

-1

0

1

2

3

Figure One: Gold: A Sensitive Leading Indicator of Inflation

since 1951

Data: Calendar-year averages of month-end gold prices (Metals Week/Wall

Street Journal) and of monthly indices of producer and consumer prices

(Bureau of Labor Statistics).


3/8

(0.73) between changes in the price of

gold and changes in 10-year T-bond

yields is about twelve months. The opti-

mum correlation (0.54) between oil-price

changes and T-bond yields involves only

one-month time difference.5 These results

reveal two respects in which the infor-

mation in the gold price is superior: gold

provides a much earlier warning, and the

correlation with interest rates is signifi-

cantly tighter regardless of the time frame.

Figure Two illustrates how oil-price

changes are not helpful in predicting

changes in the bond market with any sig-

nificant lead time. The bars record the

average response of the bond market to

whether oil rose or fell in the previous

year depending on whether the price of

gold had risen significantly, had merely

risen, or had fallen.

As the chart shows, in each category of

gold-price movement, there is little differ-

ence in what bond yields do regardless

of what happened to the price of oil. In all

three categories bond yields moved in

the same direction whether oil prices had

risen or fallen. This result is confirmed by

least-squares analysis in which we allow

price changes in gold and oil to compete

to predict the change in bond yields one

year ahead. The oil-price variable is sta-

tistically insignificant in the presence of

the gold price variable.

The triangular relationship between oil,

gold and bonds is illustrated in Figure

Three. As the diagram shows, the rela-

tionship between bond-market move-

ments and oil is roughly

contemporaneous. Gold is correlated

with both oil and bonds, but moves in

advance of both by about a year.

What makes gold different.

Because gold moves earlier than official

measures of inflation, it works much bet-

ter at anticipating monetary policy than

Fed watching. Gold distinguishes

between the relative and absolute

strength of currencies and even helps

forecast equity markets and style bets.

The investment applications of gold are

numerous, but not widely recognized.

Analysts often try to anticipate where the

price of gold is heading; however, know-

ing where it has already been is far more

fruitful. Despite growing recognition of

golds forecasting power, investors,

schooled to believe that gold is a bar-

barous relic with no modern role to play

or just another commodity, often resist

using it in their investment strategy.

Others are concerned that gold is buffet-

ed by many bottom-up factors such as

South African politics, Chinese demand,

central-bank dumping and so forth,

which can distort its price. But its fore-

casting power proves that such distor-

tions do not last long.

Why gold is not just another

commodity.

Gold has served as money over the cen-

turies precisely because its properties

were most conducive to playing that role.

Its primary function throughout history

has been as a liquid store of wealth, not

as an industrial input. Even when gold is

made into jewelry, it is still today a form of

currency in large parts of the world.

Unlike other commodities, which are pro-

duced for consumption, gold is produced

3

CONTEMPORANEOUS

Figure Three: The Triangular Relationship Between Gold, Oil

and the Bond Market

Data: As for Figure Two.

5 These correlations are measured from 1974. See Economic Barometer, Wainwright, February 25, 2005. This publication updates the status of these and other infla-

tion indicators on a monthly basis.

Figure Four: The Price of Gold is an Anchor for the Price of Oil

since 1968

Data: As for Table 1. Prior to 1984 crude oil prices are from Reuters Commodity

Research Bureau.


4/8

foraccumulation. Virtually all the gold that

has ever been mined still exists today.

Gold is the chief member of an asset class

of safe havens against the debasement

of paper money. In this class are the

other precious metals and collectibles

generally, but gold is the most liquid.

The purchasing power of gold what it will

buy in terms of other goods and services

is nearly constant over long periods of

time. The late Roy Jastram, a Berkeley

professor, in studying British and

American price indices over long time

periods, concluded that gold exhibited

relatively constant purchasing power.6

Even in the face of large gold discover-

iesin Latin America in the 16th century,

in California in the mid-19th century and

in South Africa and Australia starting in

the 1890s the world supply of gold

increased only incrementally each year,

and gold held its value. What about its

future value? Since gold is a depletable

resource, and large discoveries are

becoming increasingly rare, the total

stock of gold now tends to diminish each

year. Thus golds purchasing power will

remain stable, and its role as a measur-

ing rod will become still more secure.

Why gold forecasts better than

other commodities.

Gold is different because the reservoir ofgold that is traded in world markets

dwarfs any possible interruptions in the

annual flow that result from either supply

or demand. The annual flow of newly

mined gold adds only about two percent

a year to the gold supply, far less than for

any other commodity, especially oil. This

reservoir of gold stabilizes its value in

terms of other goods. For other com-

modities, short-term changes in supply

or demand cannot be so easily cush-

ioned. To build such enormous stock-

piles of other commodities is an

unthinkable task, nor would it make any

economic sense.

Because other commodities are major

industry inputs, their relative prices

change with the business cycle. Gold is

not subject to these distortions since it is

not a major input to industry. Changes in

the gold price are thus a good barometer

of changes in currency valuesand ulti-

mately in the absolute level of prices.

Since the real value of gold is roughly

constant over time, changes in the gold

price of a currency tend to reflect

changes in the markets evaluation of

that currency. The currency, not gold

itself, is variable. In effect, the gold price

is the inverse of the price of money. In

other words, the quoted price of gold is

the price of paper money in terms of hard

money. A rising price of gold reflects

inflationary forces; a falling price of gold

reflects dis-inflationary forces. Gold is the

only money that cannot be debasedon

the contrary, it is the measure of curren-

cy debasement. Whether the price of

gold is active or quiet, whether or not

central banks ignore its movements, it is

always measuring paper money.Those who misjudge or downplay the

importance of gold have often been sur-

prised. When the U.S. severed the dol-

lars link to gold, monetarists

predicted that the price would fall below

$35 an ounce. They believed gold was

just a commodity whose price happened

to be fixed by government and that the

dollar imparted value to gold, not

the reverse.

The implications of a gold-price change

are far-reaching. It is partly because gold

is so uninvolved in the economy that it can

serve as a dependable barometer of the

dollars purchasing power and there-

fore of pressures on inflation and bond

markets.

The relative performance of gold and oil

as inflation indicators can therefore be

traced back to one profound fact: in

order to use gold for its main economic

purpose (the preservation of wealth) it is

necessary only to hold it.

By contrast, in order to use oil for its main

economic purpose (the production of

energy) it is necessary to consume it lit-

erally to destroy it in the process of con-

verting it to energy, water, and carbon

dioxide. New supplies of oil must be

found to replace all the oil that gets used,

whereas the supply of gold is unaffected

by its use. Thus the value of oil in terms

of other goods is highly variable; the

value of gold in terms of other goods is

highly stable.

When looking for yardsticks to assess

prices and values, it is essential to adopt

a sound unit of measurement. Oil is high-

ly variable. The dollar can be highly vari-

able too. But the purchasing power of

gold is stable.

The co-movement of oil and

gold prices.

The ratio between the prices of oil and

gold, over the long haul, has been some-

thing like a natural constant.7 From the

late 1950s to mid-1973 the dollar-price of

oil hardly changed, while that of gold


4N O V E M B E R 2 0 0 5

6 Roy W. Jastram, The Golden Constant: the English and American Experience, 1560-1976, New York: John Wiley & Sons, 1977.7 For a recent estimate of the long-term norm for the oil-gold ratio, see Energy is too high-priced to be a good strategic bet, Strategic Asset Selector,

Wainwright, March 10, 2005.


5/8

escalated 250 percent from $35 under

the Bretton Woods system to over $120

an ounce. Then late in 1973 came the

Saudi oil embargo and a nearly 300 per-

cent leap in the price of oil. While the

Arabs were held responsible at the time

for an arbitrary and destructive price

action, from a more detached viewpoint

they were mostly playing catch-up with

the price of gold.

During the Carter years, the U.S. initiated a

second round of dollar depreciation. The

gold price was allowed to rise another 300

percent, undermining OPECs pricing and

precipitating the price increase that ensued

during the second OPEC shock. By the

end of 1980, oil had risen nearly 150 per-

cent, momentarily restoring parity.

In 1981,this upward spiral ended, but the

game of catch-up resumed in reverse.

During Reagans first term, the price of

gold fell more than 50 percent from an

all-time high of $800 in early 1980. The

price of oil finally broke with a drop of

more than 50 percent in the first quarter

of 1986. In the next phase both prices

fluctuated, but by 1990 the gold-oil price

ratio had once again returned to its long-

term norm, which we estimate of about

15.5. During the 1990s oil and gold

prices declined together, only to leap up

again in the new century.

Figure Four charts the history of oil and

gold prices since 1968.

As Figure Four suggests, the dollar-price

of oil has revolved around movements in

gold. This behavior accords with the idea

that the price of gold reflects inflationary

pressures in general, while that of oil

contains information specific to the

energy sector, a conclusion confirmed by

statistical tests.

Conclusions

Inflation is a monetary phenomenon, by

which we mean it is governed by the pur-

chasing power of a currency in terms of

hard money benchmarks. How to tell

whether government actions are com-

bating or accommodating inflation?

Watch gold, not oil. The price of gold is a

reliable barometer of the value of the

dollar; the price of oil is not. The effect on

official inflation statistics and bonds alike

is reliably indicated by how far policy

actions have allowed the price of gold

to rise.

5


6/8

Wainwright Economics conducts

research on the performance of U.S. and

international capital markets and their

forecastability. We produce comprehen-

sive quantitative analysis of top-down

historical data. Comparable work is not

available from any firm on Wall Street or

in the City of London.

We know all of our clients personally, visit

them regularly and are available to

answer their questions when they need

an answer.

Since we are not affiliated with any bro-

kerage firm, we have no vested interest in

how our forecasts affect the trading

habits of our clients. Out work is disci-

plined, quantitative, rigorous and total-ly impartial.

Our output is practical and designed to

facilitate real-life asset-allocation deci-

sions. We publish monthly forecasts for

the performance differential between

stocks and bonds, stocks and cash,

large-cap and small-cap stocks; value

and growth stocks; low-quality and high-

grade bonds; foreign and domestic

bonds; and for many other asset classes.

Our work provides a much-needed chal-

lenge grounded in rigorous historical

research to the clamor of seat-of-the-

pants rhetoric. Our conclusions often

conflict with the Wall Street consensus,

and when they do, we turn out to be right

the majority of the time. Our track record

is unambiguous and monitored and pub-

lished regularly.

Our methods are very different from

those of Wall Street. We do not base our

assessments on data produced by the

government but rely solely on financial-

market prices whose superiority as lead-ing indicators we have documented in

detail.

Our philosophy is to follow an investment

discipline relying on facts rather than the-

ory. Our work is not based on theoretical

economics; in fact we often discover that

academic theories are contradicted by

history. Our research is devoted solely to

observation of the data. We test and

retest our conclusions to insure that they

are sound.

We are specialists in identifying, testing

and using statistical relationships to

determine the implications of price move-

ments in one market for other markets.

We explore relationships that are either

unknown or poorly understood on Wall

Street.

We do not use black boxes. All of our

equations are made available to our

clients, and we help with their own quan-

titative modeling in forecasting. Our

clients have the benefit of the longevity

and depth of our experience in the invest-ment arena.

We are one of the oldest investment

research firms in the world. Our current

array of publications and services has

evolved out of more than twenty years of

pioneering work in the field of investment

science.


6N O V E M B E R 2 0 0 5

Approach and

Investment Philosophy


7/8

7

H.C. Wainwright & Co.

Economics, Inc.

R. David Ranson

President and Director of Research

H.C. Wainwright & Co. Economics, Inc.

South Hamilton, MA

R. DAVID RANSON is the president ofH.C. Wainwright & Co. Economics, Inc., an investment research firm near Boston,

Massachusetts. Prior to becoming a general partner ofWainwrightin 1977, Mr. Ranson taught economics at the University of

Chicago Graduate School of Business. He has been an assistant to then Treasury Secretary William E. Simon, and a member of

George P. Shultzs personal staff at the Office of Management and Budget. Prior to his service in Washington, he was a member of

the Boston Consulting Group. David Ranson has addressed audiences and published articles on a wide range of economic and

investment topics, and has provided testimony to a number of Congressional committees. His work has also appeared in The Wall

Street Journal, The New York Times, The Christian Science Monitorand other publications. He holds M.A. and B.Sc. degrees from

Queens College, Oxford, and an M.B.A. in finance and a Ph.D. in business economics from the

University of Chicago.

205 Willow Street, Suite B-300 South Hamilton, MA 01982, U.S.A.

(978) 468-4575 (800) 655-4020 Fax (978) 468-9075 www.hcwe.com


8/8


8N O V E M B E R 2 0 0 5

Disclaimer

This report is published by the World

Gold Council (WGC), 55 Old Broad

Street, London EC2M 1RX, United

Kingdom. Copyright 2005. All rights

reserved. This report is the property of

WGC and is protected by U.S. and inter-

national laws of copyright, trademark and

other intellectual property laws.

This report is provided solely for general

information and educational purposes.

The information in this report is based

upon information generally available to

the public from sources believed to be

reliable. WGC does not undertake to

update or advise of changes to the infor-

mation in this report. Expression of

opinion are those of the author and are

subject to change without notice.

The information in this report is provided

as an as is basis. WGC makes no

express or implied representation or war-

ranty of any kind concerning the informa-

tion in this report, including, without

limitation, (i) any representation or war-

ranty of merchantability or fitness for a

particular purpose or use, or (ii) any rep-

resentation or warranty as to accuracy,

completeness, reliability or timeliness.

Without limiting any of the foregoing, in

no event will WGC or its affiliates be liable

for any decision made or action taken in

reliance on the information in this report

and, in any event, WGC and its affiliates

shall not be liable for any consequential,

special, punitive, incidental, indirect or

similar damages arising from, related or

connected with this report, even it noti-

fied of the possibility of such damages.

No part of this report may be copied,

reproduced, republished, sold, distrib-

uted, transmitted, circulated, modified,

displayed or otherwise used for any

purpose whatsoever, including, without

limitation, as a basis for preparing deri-

vative works, without the prior written

authorization of WGC. To request such

authorization, contact [email protected].

In no event may WGC trademarks, art-

work or other proprietary elements in this

report be reproduced separately from the

textual content associated with them; use

of these may be requested from

[email protected].

This report is not, and should not be con-

strued as, an offer to buy or sell, or as a

solicitation of an offer to buy or sell, gold,

any gold related products or any other

products, securities or investments. This

report does not, and should not be

construed as acting to, sponsor, advocate,

endorse or promote gold, any gold

related products or any other products,

securities or investments.

This report does not purport to make any

recommendations or provide any invest-

ment or other advice with respect to the

purchase, sale or other disposition of

gold, any gold related products or any

other products, securities or investments,

including, without limitation, any advice

to the effect that any gold related trans-

action is appropriate for any investment

objective or financial situation of a

prospective investor. A decision to invest

in gold, any gold related products or any

other products, securities or investments

should not be made in reliance on any of

the statements in this report. Before

making any investment decision,

prospective investors should seek advice

from their financial advisers, take into

account their individual financial needs

and circumstances and carefully con-

sider the risks associated with such

investment decision.

Documents

Gold Not Oil Inflation (3)