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M3 Inflation and the Gold Price

In a recent post  an alternative proxy of inflation was created which was very basic in concept. Basically the idea was that the annual growth in money supply minus short term interest rates would represent the general level of inflation and deflation in an economy. The argument is that the annual growth rate in money supply represents how much each year your individual units of currency are being devalued by inflation, however with those units of currency anyone can derive income from interest rates. Therefore to get a good proxy for inflation/deflation, the level of devaluation (M3 growth rate) must be adjusted for the common level of revaluation (short term interest rates). When the two measures are combined using Australian data the following results are found for the last several decades.

M3 Inflation - Australia

Source: RBA statistics

This chart suggests that Australia has in fact experienced several periods of deflation in recent decades, before the early 80′s recession, before the 87 stock market crash and during the early 90′s recession, with several little bouts of deflation during the 1970s. What the chart actually suggests is that dips into deflation are infact common and what is actually uncommon is the last 15 years of nearly constant and rising inflation (which is currently nearing an end). All things being equal if a period of short bouts of inflation and short bouts of deflation are followed by a long series of inflation then one would expect a long period of deflation to follow. Something that time will no doubt reveal one way or another.

But back to gold, charts from the predecessor of this post were shown on a forum called talkfinance in this thread. One keen observer noted the chart from the Real Inflation and Real Deflation post which revealed the accumulation of M3 Inflation over time, the graph showed a rapid acceleration in the 1970s, then a slow deflation over nearly 20 years followed by another long accelration from the 90′s to today. The comment was made that this chart closely followed the pattern of the nominal price of gold over the same period. The data was examined and this did indeed turn out to be correct as the following chart demonstrates.

M3 Inflation and Nominal Gold Price

Source: RBA statistics and http://www.wrenresearch.com.au/downloads/

It just so happens that the gold price does track the same basic pattern over the last 40 years since the gold price was unshackled in 1971. If we assume the blue line is cumulative inflation then an argument can be made that the price of gold does indeed track closely to inflation. In fact after a quick calculation the price of gold and our representation of cumulative inflation show an 80% positive correlation. That’s not brilliant, but it is also pretty good, when you think of all the different factors that impact independantly upon the gold price and this M3 inspired measure of inflation then an 80% correlation is very good.

There have been a lot of articles written on both sides of the gold and inflation debate, this one is novel amongst them all as far as I know. Hopefully this branch of my research will get further developed as more information and thinking time is available. Comments from both gold bugs and non gold bugs would be most appreciated.

  • http://www.talkfinance.net/f3/inflation-data-not-representative-1900/index3.html#post9935 Inflation data ‘not representative’ – Page 3

    [...] got around to writing up a post on the subject mentioned by nickmakwell. It can be found here. M3 Inflation and the Gold Price « deflationite.com Basically the alternative inflation proxy I cam up with corresponds quite closely to the nominal [...]

  • http://profiles.google.com/bron.suchecki Bron Suchecki

    Seems like the gold price follows with a three year lag, interesting.

  • http://www.TheTailDoesNotWagTheDog.blogspot.com/ dnarby

    Until about 2000, when they rise together. Gee, what happened in 2000? Hmm….

  • http://intuitivereason.wordpress.com/ intuitivereason

    It looks interesting, but probably requires a degree of confirmation from charting done on other countries data to be significant.

    The (Monetary Expansion rate – Interest rate) chart is probably a good measure of the ‘forcing’ that the Reserve Bank is applying – the differential between what the interest rate is and what it would be if left to market devices.

  • http://www.thewealthmagic.com/stock-market-basics-major-guidelines-to-be-successful-investor.html stock market basics

    It’s seems to be insane after seeing the graph

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