Gold price has a positive correlation with money supply growth, according to a new empirical study produced by the World Gold Council, a fact that is extremely pertinent in today's environment of elevated money supply growth. Moreover, money supply growth tends to precede gold price increases by 6 to 9 months. As money supply increases, gold price rises. This trend is upheld by the quantity theory of money which illustrates that money supply has a direct, positive relationship with the price level. It shows divergences caused by inflationary expectations may last for a very long time, even decades, but the long-term price of gold is driven by global money supply. The paper also shows that a surge in the price of gold is an advance signal of higher velocity of money and, consequently, future inflation pressures. The findings of the paper, “Linking Global Money Supply to Gold and Gold to Future Inflation, suggest that investors may be justified in their concerns that quantitative easing measures will lead to an increase in the velocity of money and in turn inflation, give In the WGC analysis for the month of January this year, if also noted that changes in the US money supply do not solely explain the changes in the price of gold. “On the contrary, gold is impacted by many factors world-wide and as such, money supply changes in places like India, Europe, and Turkey also have an effect on its performance,” said Juan Carlos Artigas, WGC investment research manager based in New York and author of the report. In particular, a 1 percent change in money supply in the US, the European Union and United Kingdom, India, and Turkey tend to correlate to an increment in the price of gold by 0.9 percent, 0.5 percent, 0.7 percent, and 0.05 percent, respectively. Gold is an indicator of future velocity of money, in particular in the US, the report said. “In other words, the gold price can be interpreted as a signal that the market expects the velocity of money to increase, thus raising future inflation pressures,” he added. Gold is a leading indicator of velocity and therefore inflation, it noted, adding that despite a large output gap around the world and anemic economic recovery, investors are justified in their concern that quantitative easing policies resulting in rapid money supply growth will eventually lead to an increase in the velocity of money and of inflation. Many central banks across the globe base their monetary policies using the principle that inflation can be regulated by the amount of money supply pumped into the economy, the report said. It is mostly accepted that as the velocity of money increases, this creates inflationary pressures in the economy, holding everything else constant. When the global economy started to contract as a result of the financial crisis, most central banks needed to use unprecedented measures to veer the economy away from a global depression. These included lowering benchmark rates to record lows and adopting quantitative easing in one form or another. However, these same measures are prompting fears that inflation may loom on the horizon. A common, albeit simplistic, way to measure the velocity of money (not an easy task) is to compare the gross domestic product of a country to money supply. In other words, one compares the output an economy is producing relative to the money available. Using this simple approach, we compare the price of gold versus velocity of money in the US and find that, gold is usually a leading indicator of such a measure, with an average 1-year lag. In other words, a gold price increase can be interpreted as a signal by the market that the velocity of money and thus, inflation, may raise in the future. A simple empirical regression model illustrates that a 10 percent increase in the price of gold tends to increase the velocity of money in the US by about 0.4 percent in 12 months time. Hence, the present price of gold is a signal that the market is expecting velocity to pickup in a year, on average. On Thursday, gold, which typically trades opposite the dollar, fell $49, or 4.4 percent, to settle at $1,063 an ounce. It's the lowest gold has traded since early November. One of the reasons why movements in the price of gold precede changes in velocity has to do with the fact that GDP is used to compute velocity. An increment in money supply to reactivate the economy does not translate in an immediate GDP growth, the report indicated. As future growth starts fuelled by the availability of money, it increases velocity with a lag. Thus, creating future inflation may follow. “Empirically, we observe that a increase in the price of gold can also be interpreted as a signal by the market that velocity may rise in the future which in turn can produce inflation forward,” Artigas said. However, a more interesting result is that a 6-month to 9-month lag in money supply growth increased the corresponding correlation to a range of 0.15 to 0.4. In other words, there is evidence that money supply growth has an impact on future gold performance. The report also analyzed the impact of money supply in Canada, Japan, Australia, China, Russia, and Brazil to the performance of gold, without statistically significant results once the effect of the other countries was taken into consideration. There were two main reasons for this. For some countries like Canada, Japan, and China, the effect of their money supply considered in isolation showed a positive relationship with respect to gold. However, once other countries were included in the model, their effect was no longer statistically significant. This was, in turn, a byproduct of high correlations between money supply of the countries considered (or the so-called multicolinearity), so the extra variables were redundant.
