Merryn's Blog

How deflation could push up the price of gold

Most people see gold as a hedge against inflation. But a bout of ‘proper’ deflation could push it up too, says Merryn Somerset Webb.

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Most people think that holding gold is all about insuring yourself against inflation. Hold something that has always held its value over the long term even during hyper-inflation and you will have something to fall back on. And, of course, gold reached its record high in real terms back in the inflation spikes of the 1970s.

But as we have said before, holding gold is as much about protecting yourself from the unknown as from inflation itself. History shows that gold prices tend to go up in times of trouble whatever that trouble is.

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As a note out from Capital Economics today points out, gold's amazing bull run from 2002 to 2007 took place against the background of generally very low inflation, so "other drivers can clearly dominate". Deflation could very easily be one of those drivers.

That's partly because deflation (which, to be clear, we don't really have yet at all) means interest rates will stay lower for longer something that keeps the opportunity cost of holding gold very low (see my column on this from earlier in the week) while pushing up the odds of future inflation .

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It's also partly because proper deflation in a high-debt environment "can cause substantial financial and economic strains". In the eurozone, a sharp rise in the real cost of debt servicing could even end up "fatal for the weaker economies."

Capital's final view with which we entirely agree is that "the wider implications of a lengthy period of deflation, even one triggered by a favourable shock such as cheaper oil, should strengthen rather than undermine the price of gold."

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