Gold Against Inflation

There must be a lawsuit in this somewhere - breach of promise or false advertising, or maybe dereliction of duty.

Gold, long touted as investors' ultimate guard against inflation, has wandered away from its post and can no longer be counted on to fulfill that high obligation.

Its performance of these duties has been problematic for some time. Market action in early September only confirmed our worst suspicions.

"Gold prices in New York rose as an unexpected decline in U.S. producer prices helped send the dollar lower," a Bloomberg News story reported Sept. 10.

Let's take this step by step. The government reported that producer prices excluding food and energy dropped 0.1 percent in August. That's good inflation news, by any reasonable standard. Since the price of gold traditionally rises and falls with inflation, it ought to have declined.

Not this time. Seems that a better than expected signal on inflation caused traders to scale back expectations of how much the Federal Reserve might raise interest rates. Lower U.S. interest rates imply less international demand for dollar-denominated bonds. So the dollar declined in value against other currencies such as the euro.

This tells us where gold has gone - the foreign exchange markets, where it has taken up the role of the anti-dollar. Dollar weak, gold strong, and vice versa.

Some will say this isn't a complete departure. Inflation, after all, is a problem that afflicts currencies, attacking their purchasing power - so gold is still hanging out in the same neighborhood.

Something has changed, though, and that something is a basic relationship most investors once assumed to be permanent. Gold has now put us on notice not to take it for granted as a simple inflation hedge.

Consider that sector mutual funds specializing in precious metals have fallen for 2004, even as inflation expectations have risen. In Bloomberg News's monthly survey of more than 50 economists, the average estimate for the increase in the consumer price index this year is now 2.8 percent, up from 1.8 percent the first week of January.

This is unsettling because one of gold's supposed selling points is its solidity. So much about it, from its namesake color to its place at No. 79 in the periodic table of elements, never varies. Well, its financial properties don't appear so immutable.

To compound the offense, if this can happen to gold, then no other simple relationships in markets are trustworthy either. Whatever a rise in interest rates used to mean for stocks, say, the old formula might not apply now.

While the current economic cycle may resemble previous ones in many particulars, what interest rates did at this point last time might not happen this time.

Without such anchors, the poor investor is left adrift. The reassuring news is, maybe this is not such a bad thing.

It's good to be reminded to resist two-dimensional thinking in a three (or more) dimensional environment. If I can't use simplistic rules to time the market, maybe I'll stop trying and save myself a lot of trouble.

As a substitute, maybe I'll look to risk-managing methods such as diversification, which has characteristics that are trustworthy. One of these: The smaller a percentage of my money I allocate to a given class of assets, the less it can hurt me if things go wrong.

A fresh look at gold also encourages perspective. If we thought we knew a lot in the past and have since been proved wrong on at least some points, how smart is it to think we can see everything clearly now?

For investment purposes, a lesson in humility like this might be worth its weight in gold.