What makes the price of gold go up? Part 1: Inflation
There are so many factors in what makes the price gold up that it can be scary. Before researching this topic, my own opinion was "anything bad for the economy". That may be the case, but while a bad economy is often sufficient, it is far from necessary. Get ready to delve into the financially complex and yet strangely common-sense world of how inflation makes the price of gold go up. In future articles, I'll talk about other factors from human psychology to trade wars.
What Causes Inflation?
There are two main causes of inflation: "cost push inflation" and "demand pull inflation".
The first type, cost pull, causes the dollar to lose value due to the fact that companies have to pay more for things so they pass those costs on consumers, thus making products more expensive.
The second, demand pull, happens when manufactures reach the maximum amount of production of goods and services in spite of exploding demands.
Why Bother with what Makes the Price of Gold Go Up?
To some of us gold investors it seems like a natural question. Obviously, we want to understand what makes gold go up so that we can get the better of the market, or at the very least understand long-term trends. In my opinion, nobody can accurately forecast gold prices in the short-term.
Sure, major events and such are obvious enough to see short-term results. Moreover, answering what gold will do tomorrow tends to be easy: almost the same it did today. And 99% of the time, you would be right. So what? If you have ever thought about 24-hour investments, you will know that they are unpopular for several reasons. In primacy, betting against the market is not cheap and if you are wrong, your option is worthless... Not only are binary options bona-fide gambling both on the market and credit of your counter-party, but they are banned in Canada and other countries.
When you look to 6-months to 5-year gold market trends, there isn't much there. On the other hand, longer periods can be revealing.
Inflation is a Potent Part of What Makes Gold Prices Go Up.
Looking at the above chart, you may not see that at first. In fact, the price of gold does not seem to beat the inflation rate as measured by the US Consumer Price Index (CPI). Now, look at the proposition more carefully. That is, as inflation makes things more expensive, gold becomes more expensive. Unlike many assets, gold grows in value as our money becomes declines in value. And historically, it does so very reliably.
So there is a high positive correlation between inflation and gold price. When inflation rises, gold rallies. But what is inflation? Inflation has to do with the increase in prices of goods caused by the increase of money supply. According to Investopedia, inflation is really the rate that prices for goods and services go up and the rate your money's buying power goes down. Despite government attempts to control inflation through fiscal and monetary policy, it is inevitable and healthy. Some inflation is healthy because it encourages people to lend money to productive business at an interest rate. Aggravated by poor policy and the over-creation of fiat currency, however, and it can destroy trust in "paper money," businesses, and lives along with it.
Why Does Gold Enter the Inflation Game?
Although not a total guarantee, rising levels of inflation do tend to raise gold prices. Inflation is a sign of growth and expansion, and when the economy is expanding, the Federal Reserve tends to expand money supply.
Now, as inflation increases. the value of monetary notes dilutes. This makes it more costly to buy assets, such as gold. Recently, inflation has been relatively stable (just above 1%). This is one reason why gold prices have been held down.
The Bottom Line
Inflation has a direct effect on the price of gold. The level of inflation on the U.S dollar has an immediate effect on the price of gold and other precious metals.
If you are looking at gold prices, it is most likely a good idea to look at how well the economies of certain countries are doing. As economic conditions worsen, the price will usually rise. Typically, investors use gold as a "hedge" or "insurance" against a debased currency. Gold is a commodity that is not tied to anything else; it makes a good diversifying element for a portfolio.