uploads/2014/12/Inflation.png

How decelerating inflation affects gold prices

By

Updated

Inflation hedge

Investors tend to hold gold in their portfolios as an insurance against inflation. When inflation is high, the value of paper currency falls in terms of the goods and services it can buy. Investors want something that doesn’t lose its value.

So gold usually has a direct relationship with inflation. Demand for gold increases as inflation increases and vice versa.

US inflation measures

The two common measures of inflation in the United States are the CPI (Consumer Price Index) released by the U.S. Bureau of Labor Statistics and PCE (personal consumption expenditures) issued by the U.S. Bureau of Economic Analysis. The major differences between the two measures is in the composition of the basket of goods and weights. CPI usually runs half a percentage point higher than PCE inflation, and the Fed states its objective in terms of PCE.

Decelerating inflation

CPI inflation increased by 1.3% in the 12 months through November 2014 after rising by 1.7% in October, September, and August. CPI declined 0.3% in November on a seasonally adjusted basis. The gasoline index posted its biggest decline since December 2008 and was the main cause of the decrease in all items index.

The core PCE index of 1.41% was down from the previous month’s 1.53% year-over-year. Both these inflation indicators have been moving in the wrong direction from the Fed’s target of 2% core PCE inflation.

Low inflation trends in the economy usually lead to strong purchasing power for the general public. With inflation remaining low, gold isn’t very attractive. On the other hand, PCE inflation below the Fed’s target rate of 2% will deter the Fed from hiking interest rates. This should be positive for gold. We’ll talk about the relationship between real interest rates and gold prices in the next article in this series.

Slowing inflation is negative for gold stocks. But as long as it keeps the Fed from hiking interest rates, it should be positive for gold prices. Gold prices, in turn, affect companies such as Goldcorp Inc. (GG), Barrick Gold Corp. (ABX), Agnico Eagle Mines Ltd. (AEM), and Kinross Gold Corporation (KGC). Gold prices also affect gold-backed ETFs such as the SPDR Gold Shares (GLD) and the Gold Miners Index (GDX). These ETFs invest in all the stocks we’ve mentioned.

More From Market Realist