Kitco In Focus: The Consumer Price Index and Spot Price of Gold, plus Reader Feedback

Purpose of KitcoIn Focus

The purpose of Kitco In Focus is to bring to our viewers a perspective regarding the precious metals market with the hope of shedding clarity on the complex nature of this market. At least initially, the aim for this series of articles is to pull out those relevant factors that play some role in the market and explain them each in turn so that we can gain a better understanding of key concepts introduced by various authors who have worked diligently within the precious metals industry. 

It is in my hope that Kitco In Focus will also be inspired by our readers in terms of what they would like explained or the questions they would like to bring to the table. In regards to this, I am sure we all know that there are various ways to understand, explain, and analyze any given topic and that these various ways can be competing bodies of knowledge. I really want to be clear on this because there is no universal or agreed upon way of understanding all of those important and not so important factors that influence the precious metals market. I hope to bring most of these perspectives to the table, although not all at once or within one article, so that our readers can have a comprehensive understanding of the dialogue that exists within this industry. I want to stress that even in my attempts to do this, others may not share the perspective that is presented and that I think this is completely natural and healthy in any honest dialogue that exists on any given topic. We all want to arrive at the best understanding of the market we are all so very passionate about, myself included.

With this said, Kitco In Focus is written as a tribute to all of those who frequent our site and for those who would like a deeper understanding of those economic factors that are commonly assumed to play some role in our market. I hope that you enjoy.

The Consumer Price Index and the Spot Price of Gold

Often times, in the media, we will hear various explanations on why we are observing the spot price of gold to be at some given level and why we should make an investment in gold now rather than later. Included in this reasoning are a collection of macroeconomic aggregates, which are nothing more than a set of economic variables, that are readily observed to be of either direct or indirect influence on gold’s price. For this week’s In Focus, I will consider one macroeconomic aggregate, inflation as measured by the Consumer Price Index, CPI.

If you are new to the market for gold, you may wonder what does the data on inflation supposed to tell us and if the CPI does a good job of giving us the information we need in order to make an investment decision. Here, I will briefly address whether the CPI is a good measure of inflation as well as present one argument detailing how concerned we should be about inflation in light of the daily volatility that is clearly seen in the price of gold. [As a side note, I will mention that there are other authors such as Greg Tkacz, David Ranson, Mahdavi and Zhou who have argued for the use of the price of gold as a leading indicator of inflation. Studies have shown that this can be applied in a limited fashion, but only for a few selected countries. Obviously, there is a reversal in causation here: the price of gold gives us an indication of inflation and not vice versa. Also, here in this reasoning, expected or future inflation is what is to be deduced from the current price of gold. Next week’s In Focus will be devoted to this very interesting subject].

To start at the beginning, one of the most widely referred to measurements of inflation is the CPI. Actually there are various forms of this Laspeyres Index. Typically, a price index can be measured either by using a fixed basket of goods and services, referred to as a Laspeyres Index, or by using a variable basket, referred to as a Paasche Index. Among the various measurements of the CPI, there is the fixed-base Laspeyres Index, such as the CPI-U (a CPI for all urban consumers) and the chained Laspeyres Index, such as the C-CPI-U (which is just a chain weighted CPI for all urban consumers). The chain weighted CPI was developed to minimize any measurement bias that exists from not accounting for new products entering into the market (like computers), improvements in the quality of a good, and/ or substituting towards a cheaper good within the same category. The result of these biases is that the fixed CPI tends to be higher than its chain weighted counterpart, giving us an imprecise measurement of inflation. For example, this year’s initial statistics on the monthly US percentage change in the CPI reveals that the CPI-U has been greater than the C-CPI-U by at least 0.2 percentage points. Some argue that fixed or chain weighted, the CPI does not do a good job of capturing inflation. I will take the position that, yes the CPI is an imperfect measurement; however, it may still give us a rough idea of changes in the overall level of prices. I also say this with the notion that any consideration of inflation regarding the role it plays in our decision making should make us think more about the long-run than the short. I will explain shortly.

What about the role of the CPI in the determination of the price of gold? You may have seen media explaining that the increase in the price of gold was the result of the latest data on inflation where the CPI for the country has been reported, which revealed an increase in the monthly average of the overall level of prices. You are also likely to have been informed that the reasoning for this is because gold is seen as an inflation hedge. That is, gold helps to preserve or even enhance an individual’s wealth or purchasing power during a period of inflation, when other assets fail to perform this function. The result is that the demand for gold has increased given new information about the state of the economy leading to an increase in its price. What is interesting about this statement is that new information regarding inflation for a particular country is actually rather old information, since, for example, the current CPI is reflecting what happened last month plus some measurement error, beyond the bias mentioned above, that will require a few more months to iron out. You see, CPI data for the month prior comes out, at least for the US and Canada, around the middle of the current month and that is just for the initial estimate. So, if CPI data is an imperfect measure of current inflation, why do people care about this statistic enough to say that it had a current day impact on the US dollar price of gold? I will wager it is because they view the data as a statistic that helps to establish people’s expectations about the near future state of the economy. Peoples’ expectations, well founded or not and by that I mean well founded on good information or not, help to foster their consumption in the current period; thereby, affecting the demand for gold in the current period. Of course, the demand side is only a partial representation of this particular market, a market where individuals are interested in gold as a commodity and as a medium of exchange. Moreover, by how much new information, such as monthly CPI data, may influence or build peoples’ expectations is virtually impossible to measure, but we can deduce that CPI data, in the short-run, may play a very minor role in the determination of the spot-price of gold and that the role it does play is that of forming only part of their expectations.    

 Lines in grey help us to see the trends the USD spot price of gold and the CPI - U

You may have noticed that the seeming effect of the announcement of new CPI statistics has a very short lived effect on the current price of gold. At other times, you may have noticed that the news has brought no effect on gold’s price. Looking at the graph above, we can see that the announcement of the CPI-U data around mid-February of 2007 regarding the increased rate for the month of January did not result in the expected increase in spot price at the time of the announcement. Instead, this additional information had no effect on the spot-price of gold for the month of mid-February to March, as we observe a severe decline in the spot price instead. How do we reconcile this information? In these cases, some authors have been able to pin-point causes that weigh more heavily in its price determination. As an observer of this particular market, we must always take into consideration that there exists a multitude of factors, some readily measurable and some not, such as consumer preferences and expectations, as mentioned above, or the effect of political unrest, that will play an ultimate role in the final price.

So, you may be asking, what is information on inflation good for? Well, first of all, I must stress that inflation is a long-run statistic. That’s one of the reasons why we shouldn’t be too concerned about the fact that last months data came out only by the middle of this month and that we are still waiting for the figures to be finalized. I think that regarding inflation as a long-run statistic is crucial. When the rate of inflation is stable on a yearly basis, we can focus our attentions on making plans for the long-run and, here, information on inflation can be used to help us determine our long-run investment position. In saying this, it can help us to determine the long-run support for the price of gold.

Comments & Questions from Readers

With the permission of the readers, I have decided to share their comments and questions with all of you. I have also included my own comments with the hope of clarifying some of the points that were raised as well as point to further discussions that I hope to address in the near future. I would like to thank all of you who have sent in your comments and questions regarding “The Consumer Price Index and the Spot Price of Gold”, as they truly help to fuel this column.

Kevin Landry writes:

“Great article.  Short term inflation has little to do with the long term price of commodities.  I am a little confused on the time frame between what is short term and what is long term.  Is six months of steady inflation long term or is it a time frame of two years? Thanks”

Dear Kevin,

Thank you for taking the time to send me your feedback. With regards to you question, six months is not long term, but I believe that the reason why you are asking has to do with the chart I provided in the article. Basically, I wanted to show a glimpse of the volatility of gold's spot price against inflation, but not take a set of data into the long term and not show just one month of data with changes in the CPI fixed for that period. If I took a set of data for a two year period, the daily volatility of the spot price of gold may not be so clear. If I took the set of data for only one month, then I would have to graph that against changes in the CPI from the month prior, as there is a lag in the announcement of the CPI statistic to the period when we decide to make a purchase. I would need to show this if we are to say that the CPI statistic released today does influence our decision to make a purchase today. When readers see a basically fixed measure of inflation against daily changes in the spot price of gold it may lead them to assume that these two sets of data are absolutely uncorrelated - A flat line against one that is fluctuating with vigor. I don't believe this to be true.

At the same time, I must consider that our decisions are not solely based on the information gathered from only one time period. Sometimes we look deeper into the past, at least beyond last month, to make some assumptions as to what the future may reveal. In this case, I had to include more than one month of information on changes in the CPI. I hope that this clarifies everything.

Take care,

Wendy

Yuri Shpir writes:

“The CPI index is not very useful when considering the actual level of inflation because this index doesn't show if the rise in price is caused by increased demand, fall in supply - very natural economic phenomena that are not inflationary... The devaluation of the currency is the real cause of inflation and could be judged by the rise of price of gold in this particular currency.” 

For the readers out there, I believe what Yuri is suggesting in the first statement is that, when considering overall performance of an economy, the CPI falls short. It simply does not give us a comprehensive picture of what is going on. The CPI does not provide us with the reasons why the overall price level has increased or even decreased. The statistic is just a recorded observation of the price level of a fixed basket of goods and services within a domestic economy at a particular point in time. Looking at this statistic is not going to tell us how we got there. The only thing it will tell us is that we are ‘basically’ there. I use the word ‘basically’ because we know that the CPI is an imperfect measure of inflation. Some of you might be wondering what is this ‘how did we get there’ that I am referring to and why would I suggest that the CPI gives us an imperfect view of economic performance?

With regards to how we got there, I will firstly mention that there are competing theories that explain a change in the price level. Yuri mentions two of them: short run supply and demand analysis and a change in the exchange rate (defined in terms of foreign currency units per one domestic unit). In addition to these two explanations, there is ‘expansionary monetary policy’, specifically growth of the money supply, which is said to be a main factor determining inflation. I hope to cover all of these stories in a future, as I do find this topic discussed within the industry and some would like an explanation.

Now, as a last point, I had briefly mentioned in The Consumer Price Index and the Spot Price of Gold that one can use the price of gold, in a limiting fashion, as an indicator of inflation. This is something that Yuri had also mentioned. Next week’s Kitco In Focus will be devoted to this very interesting topic.

I hope that I was clear on the above points. Thank you for sending me your comments and questions.

Until next time,

Wendy

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