Gold as Inflation Hedge: Fact or Fiction?

October 14, 2008 Updated: October 1, 2015

The recent stock plunge is leading many investors to commodities such as gold. (Scott Olsen/Getty Images)
The recent stock plunge is leading many investors to commodities such as gold. (Scott Olsen/Getty Images)

WASHINGTON—On Oct. 8, spot gold prices plunged from an early $913 per ounce to $901 within an hour after many of the world’s major central banks, in a joined press release, announced that they would slash interest rates. 
“Throughout the current financial crisis, central banks have engaged in continuous close consultation and have cooperated in unprecedented joint actions such as the provision of liquidity to reduce strains in financial markets,” announced America’s Board of Governors of the Federal Reserve System.
Just for the record, the Fed cut its lending rate by half-a-point to 1.5 percent. The Bank of Canada lowered its rate by .5 percent to 2.5 percent. The Bank of England, the European Central Bank, the Bank of Japan, and the Swiss National Bank all cut rates.
Historically, gold prices have fluctuated throughout periods of economic prosperity and decline. In 1980, an ounce of gold was sold at $595, declining slowly to a low of $271 in 2001, and it rose to $603 by 2006. Gold prices before 1972 were in the low $50s. 

Gold Exploration

In anticipation of gold price increases, gold exploration company Vantex Resources Ltd., based in La Prairie, Quebec, recently acquired 19 more mining claims. There’s an estimated 1.6 million tons of gold in Canada, a company press release said.

U.S. gold exploration firms, including California-based Tonogold Resources Inc., have begun drilling for gold in its Nevada Tonopah Divide Gold Project. 
Given new mining technologies and favorable markets, a number of mining companies are reopening closed mines, including the Northern Empire Mine, which is owned by Roxmark Mines Ltd., a Toronto-based company.
 
“We are highly encouraged by the increase in resources which reaffirms our belief in the commercial viability of re-opening the Northern Empire Mine,” announced Monir Younan, president of Roxmark, in a press release. “We are confident that the current resources will take the project over the threshold for commercial development.”

 Pushing Gold Investments

“Historically, gold has been a proven method of preserving value when a national currency was losing value,” advises Eagle Wing Research on its Gold Mutual Fund Web site.

Some investment professionals believe that gold funds are just like an insurance policy, which is much less risky than investing in the stock market.
 
Eagle Wing tells its customers that foreign nationals hold $1.5 trillion of U.S. debt. Should they call in the debt, the U.S. dollar will plunge and gold prices will skyrocket. Another positive is that gold demand is increasing in Asian countries as they become more affluent. 
 
Investing in gold products starts with gold bullions that range from 1 gram to 400 ounces, and then moves on to gold coins, gold certificates for gold held by finance companies, gold futures and options, gold mining stocks, jewelry, exchange traded funds (funds that are based on market price), and gold mutual funds.
 
The World Gold Council calls gold investments a “safe haven, inflation hedge, dollar hedge and excellent risk management.” 
 
“Gold is unique in that it does not carry a credit risk. Gold is no one’s liability. There is no risk that a coupon or a redemption payment will not be made, as for a bond, or that a company will go out of business, as for equity,” the Gold Council says.
 
However, investing in bullions is not the best option, according to the Baltimore-based Oxford Club, an investor’s network. Gold bullions or jewelry do not provide the holder with income or interest.
 
It is more prudent to hold exchange traded funds (ETF), which are funds linked to an index that can be traded anytime when the stock market is open. But there is one limitation: one must pay a broker fee. 

Experts Voice Caution

Central banks, which hold large quantities of gold, have announced on and off that they may flood the market by selling their gold, which can drive gold prices down. 

Historically, gold stocks have not done nearly as well as stocks in companies.
Gold is not “a good buy-and-hold for a long term investment. Gold is quite a risky investment, so it may well go up, but it can go down substantially. You see that in the fluctuation of prices over the past 20 years,” suggests Franklin Allen, finance professor at the University of Pennsylvania (Penn), in a recent report titled “Gold May Glitter, but it Doesn’t Stack up as a Long-term Investment.” The report was published by Knowledge @ Wharton (KW), a white-paper research publishing arm of the university.
Jeremy Siegel, another Penn finance professor, claims that if someone invested $1 in the beginning of the 1800s, it would have increased to less than $2 by 2006, when factoring in inflation. Stocks, during the same period, would have skyrocketed.
To see the benefit of gold investments, one must hold it for a long time, not buy when the market is rising, and sell at the first sign of decreasing gold prices, as many gold investors are known to do. 
Another drawback is taxes on profits earned from investing in gold—which hover around 28 percent. Capital gains tax on stocks and mutual funds are taxed at 15 percent. 
“Stocks generally do better against inflation because companies raise prices when inflation goes up, and company assets such as buildings and factories appreciate as well,” the KW report says. “Growing productivity also helps stock prices keep ahead of inflation. No such factor supports gold prices. Indeed, growing mining efficiency boosts gold supplies, holding down long-term price gains.”