The chart that suggests the surge in the gold price is built on a myth

The price of gold keeps going up, but I am not convinced that it will continue, and one chart illustrates my point.

Article updated: 7 August 2020 11:00am Author: Michael Baxter

Gold is not only seen as a safe refuge against inflation. Some investors see it as a hedge against the dollar. Others see it as an alternative to bonds. And I get both those arguments; I even have sympathy with them. But that is not the main reason why gold is up; that’s not the reason I keep hearing. Instead, the buy gold narrative is clear: it’s because of the fear of inflation.

I am not buying it. The world is an unpredictable place, and let me just slip into the conversation at this point the caveat I may be wrong. But I think excessive inflation is highly unlikely.

This chart illustrates my point.


The equation

There is a simple equation: PT=MV. It means that the money in circulation times the number of transactions equals average price times velocity of money.

The narrative that says inflation is certain to surge, if not go hyper, is ignoring the velocity of money.

Sure, central banks are trying to boost the economy in an attempt to pump money into the economy.

And in the US, the narrow money supply has surged.


But the velocity of money has fallen in tandem.

Whichever is the greater

There are two ways of looking at this, but they both come down to a similar argument.

You can look at the PT=MV, or you can look at the relationship between demand and supply.

If demand exceeds supply, the price goes up. If demand continues to exceed supply, we get continuous price rises; in other words, we get inflation.

Or you can say that if MV goes up and T stays constant, then we get inflation.

But whether that happens depends. Looking at the demand-supply equation; right now, and throughout the Covid crisis, which seems set to drag on for quite a bit longer, both demand and supply are falling. Whether we get inflation depends on what sees the biggest fall if supply falls faster than demand, we will get inflation. If demand falls faster than supply, we won’t.

Inflation hawks argue that fiscal and monetary stimulus will create artificially high demand. I am not convinced. Unemployment is rocketing. Those with jobs feel insecure and are likely to save more. Companies are trying to hold onto cash for as long as possible.

At the same time, issues with supply are easily fixed. There has been no collapse in underlying capacity. Once lockdowns are entirely over, companies can quickly raise output. The only factor that will stop them from doing so is weak demand. These are not the conditions that inflation is made from.

Looking at the money supply, whether we get inflation depends not only on the money supply but on the velocity of money too.

If M increases faster than V decreases, and T is unchanged, we probably will get inflation. But thanks to the insecurity created by Covid, possibly leading to higher savings, high unemployment and increased corporate savings, V is likely to carry on falling.

The gold price

So will the gold price keep going up? The economist Keynes said that the “markets can remain irrational longer than you can remain solvent.”

Regardless of what happens to the velocity of money, the buy gold narrative is so popular that I would not be at all surprised to see gold continue to rise. But in the longer term, what happens to inflation matters, and if V continues to fall, inflation is not likely to rise as high as the gold bugs believe. So for a clue regarding the gold price long-run, look at the velocity of money and look at unemployment and savings ratios.

These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Michael Baxter portrait photo
Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.

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