This article is based on the keynote speech which Barry Eichengreen delivered at the 2021 LBMA/LPPM Virtual Precious Metals Conference on September 20, 2021.
We are currently in a period of heightened uncertainty. Relations between the US and China continue to be strained, as are those between France and the Anglophone countries. There are doubts about the reliability of US alliances more generally, given the Biden administration’s unilateral withdrawal from Afghanistan. The world continues to deal with the challenge of Covid, which might die away with the progress of vaccinations or might surge anew, owing to the development of new variants and the slow pace of progress in vaccinating the Third World.
I THINK CENTRAL BANKS HAVE INVESTED TOO MUCH IN THEIR INFLATION TARGETS.
There is concern that we are now entering a period of significant chronic inflation; I am however not so worried about this. This is partly due to some current inflationary pressures that are temporary – think, used cars in the United States – but mainly, because I think stability culture is now deeply ingrained in the ranks of our central bankers.
Despite the fact that inflationary pressures could moderate somewhat going forward, it is clear that the central bankers, and the Federal Reserve (the Fed) in particular, are a bit behind the curve. The inflation forecasts of the Federal Open Market Committee (FMOC) are implausibly low. In their latest report (from the FMOC meeting on 15-16 June, 2021), it expects an increase in consumer price inflation of 3.4% this calendar year, but in order to hit that forecast, prices would actually have to be stable, with no inflation whatsoever in the third and fourth quarters of the year. This obviously is implausible, given what is already in the pipeline. Inflation is not going to fall to zero now, given the considerable fiscal stimulus to which the US is currently subject, and the various supply-side disruptions. This means that the Fed is going to have to start tapering and then raising interest rates earlier and more sharply than communicated previously, in order to damp inflation back down. It is already showing signs that it is about to alter its communication to that effect.
One of the Bank of England's gold vaults.
While I have absolutely no doubt that this is what the Fed is about to do, others – Charles Goodhart, for example – are suggesting that heavier debt burdens will empower the debtors’ lobby, which pushes for higher inflation. However, the creditors’ lobby of mutual fund investors, insurance companies and pension funds is every bit as influential. Others say that central banks will succumb to fiscal dominance, and they will hesitate to raise rates because this will increase their government’s debt servicing costs.
I do not agree with this argument. I think central banks have invested too much in their inflation targets. They have invested too much in their anti-inflationary credibility to compromise their targets in this way. So having fallen behind the curve, they are now about to rush in order to catch up, which has two implications. First, it will make for difficult choices for governments that are unable to inflate away their debts. Second, if central banks end up normalising earlier and faster than promised, they may run for the financial markets. In other words, if they can precipitate a sharp market correction, they can provoke another taper tantrum in emerging markets. This possible market turbulence is yet another source of heightened uncertainty.
Prospects for Gold
Given all this, what about the prospects for gold? Since I am not terribly worried about inflation, I see only a weak argument for investing in gold as an inflation hedge. For my money, as it were, the inflation hedge argument was not that strong in the first place. If you look at studies of gold’s historical performance as an inflation hedge, you see that gold does reasonably well in the long run, meaning over a century or so, which is much longer than is relevant for an investor’s horizon.
Over shorter horizons, gold’s correlation with inflation is erratic. Unlike others, I do not see us heading back toward a period of chronic inflation or a period of relatively high inflation like the 1970’s, when the inflation hedge character of gold was evident. Even if you disagree, I think you are better advised to hedge inflation risk by investing in say Kipps or similar, whose returns are better correlated with inflation.
Does gold perform well in periods of heightened uncertainty?
It certainly did in 2020, which epitomised that environment of uncertainty. Gold has a low correlation with other asset classes, meaning that it is a useful means of diversification. My dissertation adviser, Jim Tobin, won the Nobel Prize in Economics for his work on portfolio diversification. When he was asked at the post prize press conference to describe to lay people the implications of his findings, he said: “Well, my research showed that you shouldn’t put all your eggs in one basket.” Tobin’s advice was that when allocating your risk assets, hold the market portfolio. So, if the market capitalisation of gold is $10 trillion, a generous estimate, that of global equities is $100 trillion, that of global bonds is $125 trillion and that of global real estate is 300 trillion, this implies that gold should be 2% of a well-diversified portfolio, unless you think that you can outguess the markets.
If you look at studies of gold’s historical performance as an inflation hedge, you see that gold does reasonably well in the long run
Do cryptocurrencies provide an alternative?
There is a pronounced age enthusiasm gradient when people are asked about cryptocurrencies. I think that cryptocurrencies will remain a niche investment product for people with a gambling tendency and for people with a high risk tolerance. Cryptocurrencies are about to be subjected to rigorous regulatory oversight in the United States and elsewhere, which will diminish their appeal to people who like them for use in surreptitious transactions. The most that can be said on their behalf is that cryptocurrencies such as Bitcoin, like gold, display a low correlation with other investments, including with gold itself, so far as I can tell. If the market cap of cryptocurrencies collectively is in the order of $2 trillion, then their weight in your market portfolio, following the calculations outlined above, should be in the order of 1/3 of 1% – not very much, and absolutely not very much compared to gold.
Jim Tobin won the Nobel Prize in Economics and said: “Well, my research showed that you shouldn’t put all your eggs in one basket.” This implies that gold should be 2% of a well-diversified portfolio