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TheGoldenConstant

ClaudeB.Erb
LosAngeles,CA90272

CampbellR.Harvey
DukeUniversity,Durham,NC27708
NationalBureauofEconomicResearch,Cambridge,MA02138

ABSTRACT

InTheGoldenDilemma,ErbandHarvey(2012)exploredthepossiblerelationbetweenthereal,inflationadjusted,
priceofgoldandfuturerealgoldreturns.Thisupdatesuggeststhattherealreturnofgoldoverthenext10years
couldbeabout3%peryeariftherealpriceofgoldmeanrevertsor11%peryeariftherealpriceofgoldovershoots
anddeclinestopreviouslowrealpricelevels.Thisviewreflectsagoldenconstanthypothesisthatinflationisthe
fundamentaldriverofthepriceofgold.Ofcourseitispossibletoentertainotherhypotheses.Agoldenconstant
perspectivesuggestsafairvaluepriceforgoldof$825anounceandapossibleovershootpriceof$350anounce.

Keywords:Gold,goldenconstant,realgold,overshoot,inflationhedge.
Seeourtwoearlierpapersongold:
TheGoldenDilemma
AnImpressionisticViewoftheRealPriceofGoldAroundtheWorld

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*FirstpostedtoSSRN:August3,2015.

ErbandHarvey(2012,2013)observedthatacommonargumentmadeforinvestingingoldinthatitisan
inflation hedge, a golden constant. One way to think about the golden constant perspective is as a
collection of statements that assert that: 1) over a long period of time the purchasing power of gold
remains largely the same; 2) in the long run, inflation is a fundamental driver of the price of gold; 3)
deviationsinthepriceofgoldrelativetoinflationwillbecorrected;and4)inthelongrun,therealreturn
fromowninggoldiszero.Thereareatleasttwowaystovisuallyupdatethisview.Thefirstistolookat
thehistoricalrelationshipbetweenthepriceofgoldandacommonmeasureofinflation.Thesecondisto
lookatthemovementovertimeintherealpriceofgold,thepriceofgoldadjustedforinflation.Dothese
viewssuggestafavorableoraproblematicoutlookforaninvestmentingold?Thisupdatesuggeststhat
thenext10yearscouldbechallengingforgold.
Exhibit1illustratestherelationbetweenthepriceofgoldinU.S.dollarsandtheU.S.ConsumerPrice
IndexsinceJanuary1975,whenfuturestradingingoldcommenced.Relatedtotheideathatgoldisan
inflationhedgeistheideathatthepurchasingpowerofgoldisconstant,atleastoveralongperiodof
time.TherustcoloredlineinExhibit1isawayofthinkingaboutwhatthegoldenconstantvalueofgold
mightlooklike,ifitexists.First,wecalculatetheaveragerealpriceofgold(averageofthenominalprice
dividedbytheCPIlevel).Overourdatatheaveragerealpriceofgoldis3.46.ThelineinExhibit1issimply
theaveragerealpricemultipliedbythecurrentlevel,eachmonth,oftheCPIindex.Forexample,inJune
2015,theCPIlevelis237.8.MultiplyingtheaveragerealpricetimesthecurrentCPI(3.46x237.8)delivers
apriceofapproximately$825.Thisrepresentswhatthenominalpriceofgoldshouldbetodayifwe
assumetherealpriceofgoldisconstant.
Importantly, the price of gold has fluctuated substantially over time as well as relative to the golden
constantvalueestimate.Sincethereisnogenerallyagreedupondefinitionofaninflationhedge,some
mightseeinExhibit1evidencethatgoldisagoldenconstantinflationhedge,atleastinalongrunsense,
andothersmaylookatthesamedataandbelievethatperhapsaninflationhedgeshouldtrackrealized
inflationmoreclosely.
Thegoldenconstantisnotafactitisonehypothesisaboutthevalueofanassetthatembedstheidea
thatgoldisaninflationhedge.Itispossibletoenthusiasticallybelieveinotherhypotheses,suchasa
goldenversionofmarketefficiency(inwhichtheobservablepriceofgoldisanunbiasedestimateofthe
otherwiseunobservablevalueofgold),theideathatthepriceofgoldisultimatelydrivenbytheactions
oftheChinesegovernmentandChineseconsumers,ortheideathatthepriceofgoldisdrivenbythecost
ofproductionofgoldminingcompanies.Ofcourse,whiletheremaybeanefficientmarketexplanation
forgold,ortheChinesemaybedrivingthepriceofgold,itisworthconsideringwhetherthesepossible
drivers of the price of gold are consistent with the idea of gold being an inflation hedge.1 Do Chinese
purchasesofgoldproxyforwhatpeople,intheU.S.andeverywhereelse,reallythinkinflationhappens
to be, is an assertion that price equals value a step forward in hedging inflation, or does the cost of
production of the average or marginal gold miner really capture the story of inflation? All the golden
constanthypothesisperspectivesuggestsisthat,ifitistrue,thepriceofgold($1096inJuly2015)ismuch
higherthanitsgoldenconstantvalue($825).Anobviousquestiontoaskis,ifthegoldenconstantprovides

Anotherwayofthinkingaboutthisis:tosomedegreeitispossibletopointtosomemeasureofinflationbutitis
probablyhardtopointtosomemeasureofmarketefficiencyorofChinesegoldactivity.Alternatively,becauseit
issohardtodefineeitherofthesearguments,itishardtodisproveeitheroftheseassertions.

aguidetothevalueofgold,whattypicallyhappenswhenthepriceofgoldisaboveorbelowitsgolden
constantvalue.Followingthepathoftherealpriceofgoldmaybehelpful.

Exhibit2showshowtherealpriceofgoldhasfluctuatedsinceJanuary1975.Asmentionedearlier,the
ratioofthepriceofgoldrelativetotheU.S.ConsumerPriceIndexhasaveragedabout3.46overthistime
period.2Ofcoursethevalueofthisratiomightbedifferentusingadifferentinflationindexoraresetting
ofthebasedateoftheU.S.CPI.Thegeneralideaofagoldenconstantonlysuggeststhatonceaninvestor
thoughtfullyselectsaninflationindex,viewinginflationasafundamentaldriverofthepriceofgold,
thereisnoreasontoexpectthattherealpriceofgold,relativetothatindex,willpersistentlytrendupor
down over a long period of time. Using the U.S. Consumer Price Index3 as an arbitrary, though

Thelongrunfuturerealpriceofgold,measuredthisway,maystaythesameorchange.Iftheaveragerealpriceof
goldrisesovertimethenitdoesmorethanprovideaninflationhedge(itisanassetthatgeneratesthereturnof
inflationandanadditionalpremium).Iftheaveragepriceofgoldfallsovertimethanitmaynotliveuptoinvestor
expectationsofwhataninflationhedgeshouldbe(sinceitwouldprovidethereturnofinflationminussomepenalty).
Itisonlyiftherealpriceofgoldstaysthesame,overalongperiodoftime,thatitispossibletoconsideritaninflation
hedgewithoutaverylengthylistofqualificationsaboutwhatoneexpectsfromaninflationhedge.InTheGolden
Dilemma,ErbandHarvey(2012)examinethegoldenconstantfrom1792.
3
Erb and Harvey (2013) go beyond United Statescentric view (gold priced in US dollars and real gold prices
calculatedusingtheUSCPI)andexplore22othercountries.However,theseextracountiesdidnotaltertherealgold
priceanalysis.Therearetworeasons.Unlikestocksorbonds,whichtosomedegreearedifferentfromonecountry
toanother,goldisgoldeverywhere.Itspriceisthesameeverywhere(afteradjustingforexchangerates).Iftheprice
of gold was not the same everywhere, there would be an attractive arbitrage opportunity from buying gold
inexpensivelyinonecountryandsellingitforalotmoreinsomeothercountry.Thisideathatthenominalpriceof
goldisthesameeverywherealsoleadstotheideathattherealpriceofgoldisthesameeverywhere,eventhough
countriesdifferinthewaysthattheyhonestlyordishonestlycalculateinflation.

conventional,fundamentaldriverofthepriceofgold,thehighrealpriceofgoldhasbeenabout8.73,the
lowrealpriceofgoldhasbeenabout1.47andthecurrentrealpriceofgoldisabout4.63.4

Inthefuturehighandlowrealpricesofgoldmaybemoreorlessextremethaninthepast.Thehistorical
lowrealpriceofgoldof1.47reflectsthehistoricalvolatilityoftherealpriceofgoldanditisameasureof
howlowtherealpriceofgoldactuallysankinthepast.Itisnotanindicationthattherealpriceofgold
cannotfalltoalowerlevelinthefuture.Thehighandlowrealpricesofgoldhighlightthatevenifthere
isonaverageagoldenconstanttherealpriceofgoldhasstrayed,andprobablywillstray,farfromthis
possiblecentraltendency.Itisalsopossiblethatthefuturewillbeunlikethepast.
Thereareatleasttwowaystothinkaboutthecurrenthistoricallyhighrealpriceofgold.Oneisthatthe
realpriceofgoldmaymeanreverttowardsthehorizontalrustcoloredline,thegoldenconstantvalue
forgoldlinkedwiththeaveragerealpriceofgold.Oritisalsopossiblethatallofhistoryismoreorless
bunk,asHenryFordonceputit,reflectinganideathatboldinvestorsandinnovatorswereneverslaves
tohistory.
Meanreversionmaybeconsistentwiththeideaofalongrungoldenconstantinwhichtherealpriceof
goldmeanrevertstoitsaverage.However,inaveryobviousway,Exhibit2alsosuggeststhatwhenthe
realpriceofgoldfallsthegoldenconstantlevelisnotaflooraprotectivelineinthesandthatthereal
priceofgoldwillnotcross.Sincethefuturehasnothappenedyet,itispossibletoforcefullyopinethat
therealpriceofgoldwillnotfallbelowitsaverage,thegoldenconstant,levelinthefuture.Ofcourse,it
isworthconsideringhowrewardinganinvestmentingoldmightbeiftherealpriceofgoldfallstoits
previouslowlevel,orlower.Focusingontheideathatinflationisthefundamentaldriverofthepriceof
gold,somewhatsimilarinspirittothinkingaboutearningsorcashflow5asthefundamentaldriversof

Currentpriceofgold/CurrentCPI=$1096/237.79~4.63
Ifinflationisthefundamentaldriverofgold,inflationmaynotbemoredifficulttoforecastthanearningsorcash
flowsforstocks.

stocks, the real price of gold can be thought of as a valuation ratio. Historically has there been any
relationship between the real price of gold and subsequent gold real returns? Or, alternatively, does
valuationmatter?
Exhibit3depictsthehistoricalrelationshipbetweentherealpriceofgoldandsubsequent10yearreal
goldreturns.Historically,belowaveragerealgoldpriceshavebeenfollowedbyaboveaverage10year
realgoldreturnsandaboveaveragerealgoldpriceshavebeenfollowedbybelowaverage10yearreal
goldreturns.Sincetherealpriceofgoldiscurrentlyaboveitshistoricalaverage,Exhibit3suggeststhat
overthenext10yearsrealgoldreturnscouldbebelowaverage.Thinkingoftherealpriceofgoldasa
valuationmetricthismayseemtosuggestthatvaluationmatters.Sincethedevilisinthedetails,itdoes
anditdoesnot.Inagoldenconstantsense,valuationmatterssincedeviationsfromanormalrealprice
ofgoldareinconsistentwiththeconceptthatgoldisaninflationhedge,thelongrunrealpriceofgoldis
constantovertimeandthelongrunrealreturnofgoldiszero.Thereare,ofcoursealternativeviews,such
astheideathatthepriceofgoldequalsthevalueofgold,orabeliefthattheChinesecontrolthegold
market,inwhichtherealpriceofgoldhasnoobviousrole.
OnecanviewExhibit3asatypicalpredictivechartthatechoestheworkofCampbellandShiller(1998)
andmanyothers.TherealpriceofgoldinJanuary1975ismatchedwiththerealgoldreturnfromJanuary
1975toJanuary1985,therealgoldpricefromFebruary1975ismatchedwiththerealgoldreturnfrom
February 1975 to February 1985, etc. It may be common to look 10 years into the future in these
illustrations, however it is worth noting that it is easier to view the choice of a 10 year horizon as a
convenientconventionratherthanascientificrevelation.6

Itispossibletocomparetherealpriceofgoldwithrealgoldreturnsoverthenextday,week,month,yearorany
timeperiod.Itiscommontobelievethatifvaluationplayssomeroleinsubsequentreturnsthatitsimpactwill
probablybemoresignificantatalongerhorizon,suchas10years,thanatashorthorizon,suchasoneday.For
example,CampbellandShiller(1998)examinedtherelationshipbetweenameasureofstockmarketvaluationand
subsequentrealstockmarketreturns.Achallengewithlongrunreturnpredictabilitystudiesisthatifaresearcher,
say,hasadesiretofindevidencethatthereisausefulvaluemetricitmaynotbesurprisingtoseeevidencethat
ismoreapparentthanrealsupportingtheresearchersbeliefs.

Givenagoldenconstantperspective,Exhibit4triestoanswerthequestionhowlowmightthepriceof
goldgoifthepreviouslowrealpriceofgoldisrevisited?GiventhevalueoftheU.S.ConsumerPriceIndex
forJune2015andthepreviouslowrealpriceofgold,apossiblelowpriceforgoldisabout$350anounce.
Thisdoesnotmeanthatthepriceofgoldwillimmediatelyfallto$350anounce.Ratheritisasuggestion
that,giventhevolatilehistoryofrealgoldpricesthatexists,therealpriceofgoldoncefellto1.47andit
couldfalltothatlevelagain.Aconsiderationoftheopportunitiesandthepitfallsofaninvestmentbenefit
fromaconsiderationofprobableandpossibleoutcomes.Ifthequestioniswhatisthelikelypricefor
goldgivenabeliefinthegoldenconstantthenanansweris$825anounce.Ifthequestionishowlow
couldthepriceofgoldgogiventhehistoryofrealgoldpricesandabeliefinthegoldenconstantthenan
answerisabout$350anounce.Aternativelyitispossibletoinvokethehistoryisbunkviewandignore
thepossibility,ordeclaretheimpossibility,thattherealpriceofgoldcouldfalltoalowrealpricelevel.In
agoldenconstantcontext,$350anounceisthedownsiderisktothepriceofgoldgiventheexistenceof
agoldenconstantframework,apriorlowrealpriceofgoldandthecurrentleveloftheU.S.Consumer
PriceIndex.

If,inagoldenconstantsense,afairvalueofgoldiscurrently$825anounceandapossiblelowvalueof
goldiscurrently$350anounce,howdoesthattranslateintoexpectednominalandrealreturn?Resorting
totheconventionofpeering10yearsintothefuture,Exhibit5providesaframework.Lookatthecasein
whichinflationisexpectedtobe2%peryearforthenext10years(thisassumptioncanbecomparedwith
theJuly31,201510yearTreasurybreakevenrateof1.75%).Thegoldenconstantvalueofgoldwould
increasefrom$825anounceto$1,006anounce,andtheovershootpricewouldrisefrom$350an
ounceto$427anounce.Ifovera10yearinvestmenthorizonthepriceofgoldfellfrom$1,096anounce
to$1,006anounceitwouldexperienceanominalreturnof0.9%peryearandarealreturnof2.8%per
year.Ifthepriceofgoldfellfrom$1,096anouncetoa10yearhenceovershootlevelthenominaland
realreturnswouldbe9.0%peryearand10.8%peryear,respectively.
Exhibit5alsoshowswhat10yearnominalandrealreturnsmightlooklikeifinflationforthenext10years
was 0% per year or 1% per year. Not surprisingly, if the level of inflation differs from one scenario to
another then nominal returns differ from one scenario to another by the difference in inflation rates.
Whatmaybeabitmoreinterestingisthatrealreturnsdonotseemtovaryacrossinflationscenarios.
Regardlessofthefutureinflationratetherealrateofreturnis2.8%peryearifgolddeclinesover10years
toitsgoldenconstantfairvalue.Regardlessofthefutureinflationratetherealrateofreturnis10.8%
peryearifgolddeclinesover10yearstoitsovershootlevel.Thisobservationthatthelevelofinflation
doesnotaffecttherealrateofreturnissimilartotheobservationinErbandHarvey(2013)thatfrom
1980to2000therealreturnofgoldwasthesameinBrazilandtheU.S.eventhoughinflationrateswere
quitedifferent.


Supposeaninvestorviewsgoldasapossibleinflationhedgeandtheinvestorisabletoperfectlyforecast
inflationoverthenext10years.InahistoricalU.S.contexthowvaluablemightthisskillhavebeenin
forecastingfuture10yearnominalgoldreturns?Exhibit6providessomeperspective.Exhibit6shows
rolling10yeartotalreturnsforthenominalpriceofgold,therealpriceofgoldandtherateofinflation.
Therateofinflationhasdeclinedovertimebuttheredoesnotseemtobemuchofalinkagebetweenthe
10yearrateofinflationandeitherthenominalorrealreturnofgold.Exhibit6highlightsthatevenif
inflationisalongtermfundamentaldriverofthefairvalueofgold,itisimportanttoidentifythose
circumstancesunderwhichclairvoyantforecastsoffutureinflationwillbehelpful.

Exhibit7presentsanotherwayofthinkingaboutthevalueofperfectforecastsofinflationandtherealized
nominalreturnsfromgold.TheyaxisofExhibit7showstherolling10yearnominalreturnsforgoldand
the xaxis plots the rolling 10 year returns for both inflation and the real rate of return of gold. The
messageinExhibit7issimple.Exactlyknowingtheinflationrateoverthenext10yearsisofnohelpin
forecastingthefuturenominalreturnongold.Ontheotherhandbeingabletoknowthefuturerealreturn
on gold delivers a highly accurate forecast of the nominal return on gold. This insight should also be
obviousfromExhibit6.Inflation,measuredover10yearperiods,hasverylowvolatility.Incontrast,the
price of gold has large volatility. As a result, being able to forecast inflation does not really help you
forecastthevolatilenominalpriceofgold.
Importantly,eventhoughthereislittlerelationbetweenthenominalpriceofgoldandinflationwhen
measuredover10yearperiods,theevidenceinErbandHarvey(2012)suggeststhatgoldholdsitsvalue
overtheverylongrun.TheypresenthistoricalevidencethatthewageofaRomancenturion(ingold)was
approximatelythesameasanUSArmycaptainspay.Theyalsodetailthatthepriceofbread(ingold)
thousandsofyearsagoisaboutthesameaswewouldpaytodayatanupscalebakery.Sowhilegoldmight
protectagainstinflationintheverylongrun,10yearsisnotthelongrun.Intheshorterrun,goldisa
volatileinvestmentwhichiscapableandlikelytoovershootorundershootanynotionoffairvalue.

Conclusion
Agoldenconstantframeworksuggeststhat$825anounceisapossibleestimateofgoldsfairvalueand
thatthepriceofgoldcouldfallaslowas$350anounce.Thoughtofintermsofpossiblerealreturnsover
thenext10years,anexpectedrealreturnforgoldisabout3%peryearusingthisnotionoffairvalue
andinthecaseofanovershootscenario,therealreturnofgoldcouldbeabout11%peryear.

Dependingupononesbeliefs,thegoldenconstantframeworkmayormaynotbeausefulwaytothink
aboutthefairandpossiblevaluesofthepriceofgold.Thegoldenconstantframeworksuggeststhat
inflationisafundamentaldriverofthepriceofgoldinthelongerterm.Itiscommonforstockandbond
investorstopointoutthatstocksandbondshavecashflowsthatdrivetheirfundamentalvalues.Fixed
ratebondshavefixedcashflowsandfixedmaturities.Stockshaveexpectedcashflowsandnospecified
maturity.Goldhasneitherfixednorexpectedcashflowsanditdoesnothaveamaturity.Asaresult,itis
muchmoredifficulttodefinegoldsfundamentalvalue.Giventhechallengeofspecifyingapricingmodel,
itisnotsurprisingthatgoldexhibitssubstantialpricevolatilityevenmeasuredoverlongertermhorizons.

References
Campbell,JohnY.andRobertJ.Shiller.1998.ValuationRatiosandtheLongRunStockMarketOutlook,Journalof
PortfolioManagement,vol.24,no.2:1126
Erb,ClaudeB.andCampbellR.Harvey.2012.AnImpressionisticViewoftheRealPriceofGoldAroundtheWorld,
SSRNworkingpaper
Erb,ClaudeB.andCampbellR.Harvey.2013.TheGoldenDilemma,FinancialAnalystsJournal,July/August,vol.
69,no.4:1042.

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