Gold As An Inflation Hedge

In the long term, gold has proved itself as an inflation hedge, but not in the short term.

Gold is often viewed as the world’s oldest financial asset, possessing a reputation as a crucial safe-haven asset, particularly during times of economic turmoil or inflation. However, its current dynamics, marked by record-high prices, are driven by profound structural changes and potential future regulatory shifts.

We examine gold’s investment reliability, analyze the forces driving its ascent, and explore the “Golden Dilemma” concerning its future price path.

This blog post is based on a paper called Understanding Gold by Claude Erb and Campbell Harvey.

Related reading: –Gold Vs. Bitcoin

The Golden Constant: Is Gold a Reliable Inflation Hedge?

Gold has successfully held its value over 2,500 years. This long-term stability led to the concept of the “golden constant,” which posits that gold’s nominal price moves with inflation, implying a zero long-term real return.

However, this consistency fades over shorter periods. Gold is a volatile asset, with approximately 15% annualized volatility, similar to the S&P 500. This volatility mismatch means gold is an unreliable inflation hedge over short time spans.

Despite its volatility, gold excels as a diversifying and hedging asset:

• Diversification: Gold has maintained a reasonably stable negative 0.025 correlation with monthly S&P 500 returns, thereby reducing overall portfolio volatility.
• Crisis Hedge: Gold has proven valuable during periods of economic stress. In 11 major stock market drawdowns studied between 1975 and April 2025, the price of gold rose in eight and declined less than the S&P 500 in the remaining three. It also registered positive returns in three of the four recessions studied in that period.
• “Low” Risk: Gold has less duration risk than a 30-year Treasury bond and has delivered 12% real returns during inflation surges, in contrast to the –8% annualized real return for 30-year Treasuries during similar periods.
• Liquidity and Valuation: Gold is highly liquid and trades in major markets, ensuring ease and certainty of valuation

The Two Forces Driving Gold’s Price

Gold’s supply is extremely static; new mining production adds less than 2% to the total above-ground supply annually. This means that changes in demand have an oversized impact on prices. The current price is attributed to significant structural demand shocks:

How Gold ETFs Changed Everything

Historically, owning physical gold was difficult due to storage costs, risks, and illiquidity (dealers’ spreads typically range from 5% to 8%). Furthermore, U.S. citizens were banned from legally holding physical gold from 1933 until 1975.

The landscape changed fundamentally with the launch of the first gold-backed ETF, SPDR Gold Shares (GLD), in November 2004. This financialization of gold removed institutional constraints, transforming gold into a highly liquid asset available to pension funds, endowments, and retail investors who could now buy a share (an ETF ticket) instead of leasing vault space.

This innovation is believed to have caused a permanently higher real price of gold. Today, global ETFs hold close to 3,560 tons of gold, exceeding a year’s worth of total world production. Notably, ETF demand exhibits a strong positive correlation (about 0.71) with gold returns, suggesting that ETF investors tend to be “price chasers”.

De-dollarization and Central Banks

A second major driver is the shifting geopolitical landscape and the weaponization of the U.S. dollar. Following the freezing of Russia’s central bank assets after the 2022 invasion of Ukraine, countries like China recognized their own vulnerability to similar sanctions.

As a matter of sovereign risk management, countries motivated to reduce their dependence on the U.S. dollar are turning to gold as the logical alternative safe asset for diversification. This trend has been visible in central bank purchasing:

• Central banks purchased over 1,000 tonnes of gold in 2024, double the average of the previous decade.
• China and Russia are the key buyers, accumulating approximately 2,500 tons combined over the last 10 years.
• This central bank hedging, combined with the growth of bilateral swap lines (like those initiated by the People’s Bank of China), challenges the U.S. dollar’s reserve status by offering alternatives to dollar-dependent portfolios.