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Gold is called a bad hedge

Bullion doesn't move in sync with inflation

One of the enduring dogmas of global finance holds that gold is a safe-haven asset. The precious metal is billed as a hedge against inflation, the ultimate insurance policy against geopolitical risk and protection during periods of financial-market turmoil.

With the credit crisis and the Federal Reserve's response to it — cutting the federal funds and discount rates and injecting huge sums into the banking system — the emphasis on gold's value has lately focused on market dislocations and inflation. Although with Iran and the Middle East, not to mention other hotspots, the specter of political risk is ever present.

Investors — and there are many of them — who buy into these suppositions might as well believe in the tooth fairy.

Here's why. Gold reached a record high of $850 an ounce in January 1980. If since then the spot price of bullion kept pace with U.S. inflation as measured by the consumer-price index, gold would now be selling for $2,119.84. Instead, it stood at $732.05 in London trading yesterday, only about a third of what it should be if it were truly an effective inflation hedge.

History shows that since 1988, the correlation between bullion and U.S. inflation expectations is just 36 percent, according to Goldman Sachs Group Inc. That means the price of gold rises and falls with inflation expectations 36 percent of the time. The relationship between gold and U.S. consumer-price inflation is less, at only 23 percent. And the metal's correlation with U.S. core inflation, which excludes food and energy costs, is even lower, at 7 percent.

"Gold is often described as an inflation hedge, but in fact there are few instances in the past 20 years when gold has moved in sync with either core or headline inflation," says James Gutman, a London-based commodity economist at Goldman Sachs International. Thus, gold "should not be used as an inflation hedge," he says.

Investors seeking protection from inflation would have been better off in the U.S. stock market. On Jan. 30, 1980, the Standard & Poor's 500 Index stood at 115.20. Adjusting the index to compensate for the increase in the CPI since then would put it at 287.30 today. Yet on Oct. 3, the S&P 500 closed at 1539.59, more than five times the inflation-break-even level.

As for political risk, the inflationary expectations associated with the Sept. 11 terrorist attacks on the U.S.—arguably the most dire threat to American security since the 1962 Cuban Missile Crisis, or even World War II—had no lasting impact on the price of gold.

Sept. 11 Effect

For instance, gold was selling at $276.25 an ounce on Aug. 31, 2001, less than two weeks before the attacks; after rising to as high as $295.10, bullion was back at $274.25 on Oct. 23.

Whatever effect inflation has on gold is transmitted through the dollar's exchange rate. Since 1988, gold has moved in tandem with a basket of currencies consisting of the Australian and Canadian dollars, South African rand, euro, yen and Indian rupee 91 percent of the time, according to Goldman Sachs. And dollar weakness is often associated with inflation.

Even so, there is little to explain movements in gold prices once the currency relationship is accounted for, Gutman says.

In any event, with the 1997 introduction of Treasury Inflation Protected Securities (TIPS) in the U.S. and similar products in other countries, there's no reason to use gold as an inflation hedge. TIPS are U.S. Treasury bonds whose principal increases at the same rate as the CPI. The interest payment is then calculated from the inflated principal and paid at maturity.

Fed Rate Cuts

What's more, inflation isn't a problem currently, even though the Fed last month cut its fed funds rate by half a percentage point to 4.75 percent, and traders are betting there's a 70 percent chance it will fall to 4.50 percent later this month. American consumers expect a U.S. inflation rate of 3.1 percent in a year, according to the Reuters/University of Michigan preliminary September index of consumer sentiment.

Still, the CPI fell to 2 percent year-over-year in August, down from 2.4 percent in July and 2.7 percent in June. "It's far too early to expect higher inflation," says David Abramson, Montreal-based chief currency and commodity strategist at BCA Research Ltd.

Gold has been on a roll. It's up 15 percent so far this year, climbed to a 27-year high of $747.90 an ounce on Oct. 1 and is on course to rally for the seventh consecutive year. Behind its rise has been the abundance of global liquidity and, more recently, the Fed's relaxed monetary policy and weaker dollar.

Nonetheless, bullion has no direct link to economic growth as do other commodities, doesn't earn a return, offers limited hedging advantages and hasn't kept pace with inflation. Moreover, the world's biggest holders of gold, major central banks, aren't overly eager to keep owning it.

For investors who decide to hold gold, things may not be as easy as the past few years.