by Joseph Nicholson

Created on: February 06, 2009

The usefulness of gold as an economic indicator is highly questionable, but perceptions about the economy can certainly affect the price of gold directly. Gold is widely recognized as a hedge against declines in the U.S. dollar and inflation. Gold is used in most electronic devices like computers and cell phones, but in such small quantities that fluctuations in these markets have little effect on the price of gold and vice versa.

The balance of supply and demand for gold tends to change relatively little from year to year, so, changes in the price are largely attributed to inflation. Because rising inflation often coincides with a booming economy, a rise in the gold price is sometimes coincident with a strong economy. Traditionally, that is, after 1933, the price of gold generally reflected monetary inflation, that is, inflation of the money supply. Because the fractional reserve banking system under the Federal Reserve is inherently inflationary, the total amount of money in circulation tends to expand, at times rather sharply. If monetary inflation exceeds real growth in products and services, then the result isa price inflation, which is what is measure by government measures of inflation such as the Consumer Price Index (CPI) and Producer Price Index (PPI).

In more recent years, advances in the price of gold have resulted from a growing panic related to a possible devaluation of the US dollar or a collapse of the global banking system. Absent a reliable currency, hard money, such as gold, becomes one of the few stores of wealth. The value of the dollar reflects the health of the US economy, but in a floating currency system where the dollar is only priced relative to other floating currencies, it is increasingly difficult to use currency movements as an economic measure. Still, gold is a very popular hedge for large institutions against devaluation in the US dollar, so, as the value of the dollar goes down relative to other major currencies, the price of gold tends to move higher. When the dollar is on the rise, investors tend to flee from gold, causing the price to drop precipitously, without necessarily signaling a slowing of monetary inflation.

The price of gold is also subject to fluctuations in the mining industry, which tends to be cyclical. Because gold miners make their profit from selling gold, their profit margins are largely determined by the prevailing market value of the commodity. In past decades, miners hedged their production in the futures market to create some stability and transparency, but that practice largely ended in the first decade of the twenty-first decade as the volatility of gold and its rising price made it unprofitable to do so. Still, assuming static inflation and economic growth, a rising price for gold tends to increase the volume of mining production until the market becomes saturated and the price declines. The declining price is a disincentive to produce more gold, which ultimately creates tighter supplies and restarts the cycle.

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