### The Golden Constant

TR

**Campbell R. Harvey**

Duke University – Fuqua School of Business; National Bureau of Economic Research (NBER)

August 4, 2015

H/T Meb Faber

**Abstract: **

In *The Golden Dilemma*, Erb and Harvey (2012) explored the possible relation between the real, inflation adjusted, price of gold and future real gold returns. This update suggests that the real return of gold over the next 10 years could be about -3% per year if the real price of gold mean reverts or -11% per year if the real price of gold overshoots and declines to previous low real price levels. This view reflects a “golden constant” hypothesis that inflation is the fundamental driver of the price of gold. Of course it is possible to entertain other hypotheses. A “golden constant” perspective suggests a fair value price for gold of $825 an ounce and a possible overshoot price of $350 an ounce.

Related SSRN papers:

An Impressionistic View of the ‘Real’ Price of Gold Around the World

### The Golden Constant – Introduction

Erb and Harvey (2012, 2013) observed that a common argument made for investing in gold in that it is an inflation hedge, a “golden constant”. One way to think about the golden constant perspective is as a collection of statements that assert that: 1) over a long period of time the purchasing power of gold remains largely the same; 2) in the long run, inflation is a fundamental driver of the price of gold; 3) deviations in the price of gold relative to inflation will be corrected; and 4) in the long run, the real return from owning gold is zero. There are at least two ways to visually update this view. The first is to look at the historical relationship between the price of gold and a common measure of inflation. The second is to look at the movement over time in the real price of gold, the price of gold adjusted for inflation. Do these views suggest a favorable or a problematic outlook for an investment in gold? This update suggests that the next 10 years could be challenging for gold.

Exhibit 1 illustrates the relation between the price of gold in U.S. dollars and the U.S. Consumer Price Index since January 1975, when futures trading in gold commenced. Related to the idea that gold is an inflation hedge is the idea that the purchasing power of gold is constant, at least over a long period of time. The rust colored line in Exhibit 1 is a way of thinking about what the golden constant value of gold might look like, if it exists. First, we calculate the average real price of gold (average of the nominal price divided by the CPI level). Over our data the average real price of gold is 3.46. The line in Exhibit 1 is simply the average real price multiplied by the current level, each month, of the CPI index. For example, in June 2015, the CPI level is 237.8. Multiplying the average real price times the current CPI (3.46×237.8) delivers a price of approximately $825. This represents what the nominal price of gold should be today – if we assume the real price of gold is constant.

Importantly, the price of gold has fluctuated substantially over time as well as relative to the golden constant value estimate. Since there is no generally agreed upon definition of an inflation hedge, some might see in Exhibit 1 evidence that gold is a golden constant inflation hedge, at least in a long run sense, and others may look at the same data and believe that perhaps an inflation hedge should track realized inflation more closely.

The golden constant is not a fact ?? it is one hypothesis about the value of an asset that embeds the idea that gold is an inflation hedge. It is possible to enthusiastically believe in other hypotheses, such as a “golden” version of market efficiency (in which the observable price of gold is an unbiased estimate of the otherwise unobservable “value” of gold), the idea that the price of gold is ultimately driven by the actions of the Chinese government and Chinese consumers, or the idea that the price of gold is driven by the cost of production of gold mining companies. Of course, while there may be an efficient market explanation for gold, or the Chinese may be driving the price of gold, it is worth considering whether these possible drivers of the price of gold are consistent with the idea of gold being an inflation hedge.1 Do Chinese purchases of gold proxy for what people, in the U.S. and everywhere else, really think inflation happens to be, is an assertion that price equals value a step forward in hedging inflation, or does the cost of production of the average or marginal gold miner really capture the story of inflation? All the golden constant hypothesis perspective suggests is that, if it is true, the price of gold ($1096 in July 2015) is much higher than its golden constant value ($825). An obvious question to ask is, if the golden constant provides a guide to the value of gold, what typically happens when the price of gold is above or below its golden constant value. Following the path of the real price of gold may be helpful.

See full PDF below.