Market Insights, The US Dollar

How Does Deflation Affect the Price of Gold?

Gold Alliance disclaimer

Inflation and deflation are possible scenarios in a financial downturn. Experts disagree as to what the next financial crash will bring us, and what will be the reaction of the markets to the Federal Reserve’s reaction to the financial downturn. This means we might see a rotation between Inflation and Deflation.

Which leaves us no choice but to assess where gold stands in either situation.

Gold Prices Response to Inflation & Deflation

It is “common knowledge” that gold does extremely well under inflation but poorly under deflation. The premise is that gold rises when the US dollar falls—and vice versa. But, the same logic dictates that during deflation where prices across the board drop, as the dollar gains strength, gold loses its own. It may be time, however, to change and expand our view on the behavior of gold. What if we measure gold’s value by its purchasing power relative to consumer prices instead of by its nominal value? This means we will not look just at the price of gold (nominal value); rather, we will look at what the new price of gold enables the holder of the gold to purchase (“purchasing power”).

Gold Prices from Historical evidence

With his 1977 The Golden Constant: The English and American Experience, 1560–1976, Roy Jastram became an authority on the gold standard. He examined three historical periods of deflation:

  1. From 1814 to 1830, prices dropped by 50%.
  2. From 1864 to 1897, prices dropped by 65%.
  3. From 1929 to 1933, prices dropped by 31%.

In the first period (1814-1830) gold’s purchasing power, according to Jastram, doubled! In other words, you could buy twice as much with your gold in 1830 than 16 years earlier. Gold’s nominal value increased as well but less than its purchasing power.

During the second period (1864-1897), prices, in general, dropped 65% while Jastram claims the purchasing power of gold increased by 40% while its nominal value stayed fairly stable. Note that this period saw some of the most significant economic growth ever recorded—gold doesn’t kill growth!

In Jastram’s last example (1929-1933) prices fell by 33%. The gold price dropped as well, but its purchasing power increased by a stunning 44%!

As we can see, the purchasing power of gold jumped during all three periods, even when its nominal value dropped. Decreasing gold prices don’t matter as long as overall prices decrease more than gold.

The influence of fixed gold prices

In The New Case for Gold, author Jim Richards lays out the following:

“Assume gold is $1,200 at the start of a year, and there is 5% deflation that year. Further, assume that the Dollar price of gold at the end of the year is $1,180. In that scenario, the nominal price of gold fell 1.7%, but the real price of gold rose about 3.3% because the $1,180 year-end Dollar price is actually worth $1,240 in purchasing power relative to prices at the beginning of the year.”

The bottom line when looking at history is that deflation turns out to be good for gold when judged by its purchasing power instead of its nominal price.