Blose, L.E. (2010) Gold Prices, Cost of Carry, and Expected Inflation, Journal of Economics and Business, Vol.

62, No. 1, pp. 3547. A review by Dare Jude Nana

It is generally believed that expected inflation influences gold spot prices, Laurence E. Blose (2010) however, argued that the theory underlying this assumption is at best unclear and at worst completely wrong. Thus, he attempts to prove through empirical evidence that changes in expected inflation do not affect gold price. This sets the context for the entire research work. He listed eleven works by different researchers, the span of study, the methods used in calculating expected inflation and the outcome of their findings (Table 1). Of the eleven works listed, three concluded that expected inflation affects gold price, four find no relationship while four studies arrived at a mixed result. He proposed two hypotheses thus:
1. The Expected Inflation Effect Hypothesis, which states that increase in

inflation expectation will trigger increase demand for gold, thereby leading to a rise in gold spot price; and
2. The Carrying Cost Hypothesis, which implies that any speculative profit

realised from holding gold will be offset by higher interest costs hence, changes in inflation expectations will not affect gold prices. (p. 36) Unexpected changes in the Consumer Price Index (CPI) was used as a proxy for expected inflation. Using regression analysis for the twenty-year period from March 1988 to February 2008, the author compared changes in unexpected CPI to changes in the price of gold obtained from the London PM fixing. The result showed a negligible or insignificant correlation. (p. 43)

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Further, US government bonds were tested using the same variables and methodology. The result was statistically significant. The author argued that the bond yield tests validate the methodology and proves that the result obtained for the gold test was not due to weak test methodology or noisy data. Therefore, he concluded that gold prices do not react to changes in expected inflation. (p. 45) The findings of this study has far reaching implication for investors. According to the author, an investor can predict future inflationary trend and design investment strategies to make profits by speculating in the bond market rather than in the gold market. (p. 45) While one would readily agree that the author has a good grasp of the subject matter and presents his points strongly, it could be argued that CPI is not a suitable proxy for expected inflation in relation to gold. The Consumer Price Index is a measure of the cost of buying a fixed bundle consisting of some 400 consumer goods and services, representative of the purchase of a typical working-class urban family. The bundle consists of categories of goods such as food and beverages, housing, apparel, transportation, medical care, entertainment, etc. (Jae K. Shim and Michael Constas, 2001, p. 149) Baur and McDermott (2010), notes: The total demand for gold can be separated into three categories: demand for jewellery, industrial and dental, and investment. While the first two categories are largely determined by consumer spending power and thus, attached to the business cycle, the investment demand for gold could act counter-cyclical due to an increased demand for gold in times of global crises and recessions. (p. 1888) Hence, the price index of a typical working-class family will not adequately capture the dynamics of the gold market. The use of US CPI data with gold price data obtained from London fixing raises question of data compatibility. According to Wikipedia, (Wikipedia, Gold fixing, 1) the London gold fixing is the procedure by which the price of gold is determined for the majority of gold products and derivatives throughout the world's markets. Gold is an internationally traded commodity, easily affected by international political, economic and social crises. For instance, the gold price peak of 1980 (in the US)
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coincided with the Soviet Union's invasion of Afghanistan and the threat of the global expansion of communism (Wikipedia, Gold as an investment, section 4.2, 2). One would hardly expect any correlation between such a global commodity and local (US) CPI data. In addition, the study does not consider other factors that affect gold price. These are inflation rates, exchange rates, interest rates and the returns or prices of other securities (Ghosh et al, 2004, p. 1). Others are inflation expectations, economic crisis, international instability, and increasing demand for gold from emerging markets (Wo-Chiang Lee and Hui-Na Lin, 2010, p. 118). Gold price would rise or fall depending on how these various factors play out in the global financial market. It would be very difficult to isolate the effect of only expected inflation. A fourth weakness is the use of bond yield to validate the test methodology. A rise in either interest or inflation rate will tend to cause bond prices to drop (Gray L. Goudeau, 2012, p. 1). On the other hand, according to Dirk G. Baur and Thomas K. McDermott (2010) Gold prices appear to react positively to negative market shocks...the dramatic rise in the gold price over the past 18 months have come about during the worst financial and economic crisis to hit the global economy since the Great Depression of the 1930s. (p. 1888) Gold react in a different way than bond to macro economic variables, therefore, one cannot be used to validate the other. Bond would readily correlate with factors such as expected inflation unlike gold, which has a more complex relationship. Finally, it could also be argued that the phraseology used in the Carrying Cost Hypothesis allude to the possibility of a rise in gold price due to changes in expected inflation. It only says, Any speculative profit in holding gold during inflationary periods will be offset by the higher interest costs (Blose, 2010, p. 36) hence, it assumes that investors would have no incentive for buying gold. However, investors have traditionally used gold as a hedge against inflation or a falling dollar. If the dollar loses value, the nominal price of gold will tend to rise, thus preserving the real value of gold (Dirk G. Baur and Thomas K. McDermott,

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2010, p. 1886). It is reasonable to expect that an investor would at least settle for value preservation if capital appreciation were not possible. The issue about the relationship between changes in expected inflation and gold price is a highly controversial and hotly debated subject. Many literatures have been published on this scholarly topic with different and sometimes conflicting conclusions. Wrong conclusions may be the result of wrongly selected or poorly measured factors. More research into areas such as global inflation, factors driving gold price and their effect on inflation as well as the relationship between gold and debt instruments such as bonds and stocks would provide better understanding.

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References Baur, D.G. and T.K. McDermott. (2010) Is Gold a Safe Haven? International Evidence. Journal of Banking & Finance, 34(8), p. 1886-1888. Blose, L.E. (2010) Gold Prices, Cost of Carry, and Expected Inflation, Journal of Economics and Business, Vol. 62, No. 1, p. 35 - 47. Gosh, D., E.J. Levin, P. Macmillan and R.E. Wright (2004) Gold as an Inflation Hedge? Studies in Economics and Finance, Vol. 22(1), p. 1. Gray L. Goudeau. (2012) Bonds, Interest Rates, and the Impact of Inflation, Ameriprise Financial, Goudeau, Heyd and Associates, p. 1. Jae K. Shim and Michael Constas (2001). Encyclopedic Dictionary of International Finance and Banking, p. 149. Wo-Chiang Lee and Hui-Na Lin. (2010) The Dynamic Relationship Between Gold and Silver Futures Markets Based on Copula-AR-GJR-GARCH Model, p. 118. Wikipedia. (2012) Gold as an investment, section 4.2, paragragh 2, retrieved 15th October 2012, http://en.wikipedia.org/wiki/Gold_as_an_investment Wikipedia, (2012) Gold fixing, paragraph 1, retrieved 15th October 2012, http://en.wikipedia.org/wiki/Gold_fixing

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