How Gold is a Safe Hedge Against Inflation

Precious Metals / Tuesday, February 11th, 2020

Investors have one of three reasons to buy gold: a hedge, a safe haven, or a direct investment. Which one is the best reason for this? Research says gold represents the best hedge against a stock market crash.

What is an Inflation Hedge?

An inflation hedge is an expenditure considered to safeguard a currency’s decreased purchasing power resulting from the loss of its value due to rising prices (inflation). This typically involves investing in an asset that is expected over a specified period of time to maintain or increase its value. Instead, the hedge may include asset holding a higher position, which may decline in value less rapidly than currency value.

Hedging inflation can help protect an investment’s value. Some investments may seem to yield a decent return, but they can be sold at a loss when inflation is factored in. For instance, if you invest in a stock that yields a 5 percent return, but inflation is 6 percent, you lose purchasing power. Assets that are considered a buffer for inflation could be self-fulfilling; investors flock to them, holding their prices high even though the intrinsic value may be much lower. Gold is widely regarded as an inflationary hedge as its U.S. dollar price varies.

For instance, if the dollar loses value due to inflation impact, gold tends to become more costly. As a result, a gold owner is shielded (or hedged) from a falling dollar, as inflation rises and erodes the dollar’s value, the cost of every dollar an ounce of gold will increase. Thus the investor is rewarded with more dollars for each ounce of gold for that inflation.

Industries also participate in hedging inflation to keep their operating costs down. One of the most famous examples is Delta Air Lines purchasing a ConocoPhillips oil refinery in 2012 to offset the risk of higher prices for jet fuel. Insofar as airlines try to hedge their fuel costs, they typically do so on the crude oil market. Delta believed that they themselves could manufacture jet fuel at a lower cost than purchasing it on the market and thus explicitly hedged against inflation in the price of jet fuel. Delta at the time projected it would reduce its annual fuel budget by $300 million.

Gold As a Safe Hedge Against Inflation

Hedges are assets in another asset class that cover losses. Most investors buy gold to protect against a currency fall, usually the US dollar. As a currency falls, higher import and inflation prices are produced. Consequently, gold also provides a safeguard against inflation, which is why gold IRA accounts are becoming a trending investment.

For instance, between 2002 and 2007 the price of gold more than doubled, from $347.20 to $833.75 an ounce. That’s because, during the same period, the value of the dollar as measured against the euro fell by 40 percent.

Despite the financial crisis, some creditors managed to hedge against a fall in the dollar triggered by two new factors in 2008. One was the quantitative easing program which was launched in December 2008. The Federal Reserve exchanged loans for bank Treasuries in that plan. The Fed produced the credit literally out of thin air. Investors worried this increase in the supply of money would create inflation.

The other was deficit spending at the record level that pushed the debt-to-GDP ratio above the critical level of 77 percent. The expansive fiscal policy could create inflation. The rise in the nation’s debt may also cause the dollar to fall.

Gold prices went up sharply for 15 days after a crash. There was fear among terrified investors, who sold their stocks and bought gold. Gold prices subsequently lost value against rebounding stock prices. Investors moved money back to stocks to benefit from their lower prices. Those who were holding on to gold for the past 15 days started losing money.

A safe haven protects creditors from a possible disaster. That is why a lot of investors bought gold during the financial crisis. In response to the eurozone crisis, gold prices started to surge. The effect of Obamacare and the Dodd-Frank Wall Street Reform Act has also troubled investors. A further troubling case was the debt ceiling crisis in 2011.

Many others have been seeking protection from a possible economic downturn in the US. Gold prices have more than doubled again as a result of this extreme economic instability. On September 5, 2011, prices rose from $869.75 in 2008 to a record high of $1,895.

Gold As A Direct Investment

Most investors wanted to take advantage of those massive gold price rises. They bought it as a direct investment to capitalize on future price rises.

Many people currently keep on buying gold because they see it as a desirable finite commodity with many industrial uses. They assume this metal’s value would eventually be forced by supply constraints.

Last but not least, many governments and wealthy people hold gold. Much of it is leftover gold for the governments that have been kept in storage for decades. Since 1937, the United States Treasury has processed gold at Fort Knox, Kentucky.

The Bottom Line

Don’t think that gold can be bought as an investment by itself. Gold is speculative as a commodity and can have high peaks and low valleys. That leaves the average individual investor open to risks. The value of gold does not beat inflation over the long run. Gold is, however, an integral part of a diverse portfolio. It should be included with other assets such as oil, mining, and other hard asset investments.

That being said, gold does have a special place for investors. Gold’s characteristics also explain why it’s uncorrelated to other properties. These include inventories, stakes, and fuel. When other asset classes do, the price of Gold doesn’t rise. As stocks and bonds do with each other, it doesn’t even have an inverse relationship. This is why investors prefer to invest in gold rather than other, more unstable assets. Of course, you should always consult with a financial advisor before making any expensive investments.

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