Understanding the distinction between real and nominal measures that we use to describe interest rates and Fed policy is essential for gold investors. Despite financial and geopolitical crises in Greece, Ukraine, and Syria, as well as a Chinese stock market crash, gold investors were dismayed in 2014 and 2015.In times of stress, gold is supposed to be the "safe haven" asset. Why didn't the price rise? Better would be to ask, "Why didn't it go down more?" From June 2014 to January 2016, the dollar price of oil dropped by over 70%, while the dollar price of gold barely changed (despite volatility).In point of fact, the price of gold fared well in comparison to that of numerous leading commodities. It's possible for deflation to get out of hand, and if it does, it wouldn't be out of the ordinary for the nominal price of gold to drop even further. Assume, for instance, that gold costs $1,200 per ounce at the beginning of the year and that inflation is 5% that year.

 

Also, let's say that the dollar price of gold at the end of the year is $1,180. The year-end dollar price of $1,180 is actually worth $1,240 in purchasing power when compared to prices at the beginning of the year, so even though the nominal price of gold decreased by 1.7% (from $1,200 to $1,180), the real price of gold increased by approximately 3.3% in this scenario. Other significant prices and indices are likely to follow suit if the dollar price of gold falls even further. In a deflationary or collapsed environment, this is common. In a world with extreme deflation, goods other than gold will drop even more. When measured in real terms, gold will still preserve wealth even if its nominal value decreases while other prices decrease even more. When gold is measured in nominal dollars, it may fluctuate.

However, the volatility is more influenced by the dollar's value than by the value of gold. Gold has historically performed well during periods of inflation and deflation because it is a real value store. The reason why gold performs so well in an inflationary environment is easily comprehended by the majority of gold investors. But why is gold also successful in deflationary conditions? Deflation cannot be tolerated by central banks like the Fed, as previously stated.They will do everything in their power to inflate the market. They can always use gold to invent inflation out of thin air if all else fails by simply fixing the price of gold in dollars at a much higher level. Then, the new, higher gold price will quickly affect all other prices. The reason for this is that the higher price of gold in dollars actually indicates that the value of dollars has decreased in comparison to a particular weight of gold. For the same weight, you need to spend more money. Inflation is defined as a decline in the value of dollars. In order to achieve inflation that cannot be achieved through other means, the government can always set the price of gold in dollars.

 

When both the United States and the United Kingdom devalued their currencies in comparison to gold in 1931, this is exactly what they did. The price of gold was forced to rise from $20.67 per ounce in 1933 to $35.00 per ounce by the United States government. Gold was not pushed higher by the market; At the time, deflation was gripping the market.Inflation was caused by the government raising the price of gold. In 1933, the government didn't do that because it wanted gold to rise; It desired that everything else rise. It wanted to raise the prices of commodities like cotton, oil, steel, wheat, and others. In order to bring an end to deflation, it lowered the value of the dollar in comparison to gold. The government could unilaterally raise the price of gold to $3,000 or $4,000 an ounce or even higher in today's extreme deflation, not to reward gold investors (though it would), but to cause widespread one-time hyperinflation.

 

If gold were worth $4,000, oil would cost $400 a barrel, silver would cost $100 an ounce, and gas would cost $7 a gallon at the pump. Such significant price increases would alter inflationary expectations and snap the deflationary backbone. Gold cannot respond when currency is devalued in relation to gold, so it works. The Eurozone can respond by cheapening the euro if the United States attempts to devalue the dollar in relation to the euro. But that is the end of it if the United States lowers the value of the dollar in comparison to gold by raising the price of gold. It is impossible to magically produce more gold to bring the price back down. Gold is unable to respond in a currency war.

In other words, either inflation or deflation can lead to higher gold prices. Because there are powerful forces in both directions, it is difficult to predict which one will prevail. The fact that gold preserves wealth in both countries is what draws people to it. As was the case in the 1970s, gold prices simply rise as a result of inflation. The gold price also rises in deflation, not by itself but as a result of government orders, as in the 1930s. Because it is one of the few asset classes that outperform inflation and deflation, gold belongs in every investor's portfolio. The best kind of insurance is that one.