Gold Compared to the Velocity of Money

Monetary policies around the world are regulated with a basic premise that inflation can be controlled by regulating the money supply. Many of these monetary policies have their roots in the theories of Milton Friedman, especially his theories as it relates to policy making. It is still widely debated to what is the best model of both the measure and control over inflation as it relates to the money supply; there is not much debate that as the velocity of money increases the pressure of inflation also increases. This comment is also only true by holding all other variables constant.

In 2007, contraction was the state of the global economy. Fearing a global depression, central banks took drastic measures to offset a complete collapse. Almost all central banks used quantitative easing as one measure to stave off the economic crisis from developing into a depression. Quantitative easing is a government term for printing money. Another key measure was reducing the benchmark rates to record lows. Whether or not these measures worked or were necessary, there are new fears that higher inflation may be in our future.

An easy way to look at the velocity of money is by measuring the gross domestic product (GDP) by the supply of money. In its simplest form, the comparison is looking at the total a country produces as to the total money it has available. Using this same comparison, gold compared to the velocity of money in the United States has shown that gold may be a leading indicator of inflationary times ahead. Gold prices have been shown to have a 1 year lag time to periods of higher inflation. This is not always the case as there are other circumstances that affect the price of gold. The recent data suggests that a 10% increase in the rise of gold has led to a .4% increase in the velocity of money within the next 12 months.

Currently the past twenty years have seen a period of time which is considered pacified as it relates to inflation. This is one reason why the current economic policies have created fear of future inflation ahead. The present price of gold is one signal that the velocity of money is set to pick up.

To look at global GDP as it relates to the money supply is hard as there is a lack of good data from European Central Banks plus other countries like India and China. It is important to understand why gold is a leading indicator, when an increase in the money supply is used to stimulate the economy or GDP the results are not immediate. For this example we are using GDP as one of our factors for the velocity of money and not a factor that changes rapidly. As the growth of the economy starts to translate into increases in GDP dollars a new calculation of velocity will result.

Changes in the money supply do affect gold prices directly. As the supply of money is increased typically so do gold prices. There is usually a lag time of 6 months as the correlation is not instant. Important to understand money supply is not the only factor that affects the price of gold. Worldwide demand for gold for many reasons has increased the value of gold over the last 10 years. Research has shown that even a 1% change in the money supply can affect the price of gold to relatively the same amount.

Gold can potentially be an indicator that future inflation is ahead. An increase in gold prices has been shown to signal an increase in the velocity of money within the next 12 months. This supports many investors and economists fears that the current increases in gold prices signal high inflation in the future. It is impossible to predict what if any future inflation will hold as you can never look at any one aspect of the economy in a vacuum. What this does represent is another piece to the puzzle on what the future holds for the economy and its correlation to the price of gold.