The U.S. Federal Reserve increased the interest rate by 75 basis points, the most aggressive hike since 1994. The move came as Fed chair Jerome Powell did not see inflation easing in May. Instead, it surged to 8.2%. Rising inflation and interest rates are slowing gross domestic product (GDP) growth. The Fed has reduced its 2022 GDP growth outlook to 1.7% from 2.8% in March. Any growth below 2% is an economic standard for stagnation. This has put the United States at risk of stagflation. In the past, the gold price surged during stagflation and recession.
Gold does not perform the same way in every economic crisis
Gold is considered a safe haven, an inflation hedge, and an asset class to fall back on when the economy is not keeping well. Why so? Historically, gold was used as a medium of exchange and had a store of value until it got replaced by paper currency. In 1971, fiat currency replaced gold. Hence, gold and the U.S. dollar have an inverse relation. When the U.S. dollar is weak, gold is strong. Anything that reduces the value of the dollar increases the value of gold, like rising inflation and falling real interest rate.
While gold has proved its worth in most crises, there is no assurance it will do the same in the current situation. For instance, the rising inflation and record-low interest rate in 2021 did not trigger gold prices. It could probably be because of the recovery in consumer demand and GDP growth.
A scenario where gold price could fall
In 2022, an economic shock from Russia’s invasion of Ukraine pushed gold prices up 6% in fewer than 10 days. But the Fed’s aggressive interest rate hikes strengthened the U.S. dollar, which weighed down on gold. Gold price dropped over 8%.
The only thing keeping gold prices up is inflation. If Fed’s hawkish monetary policies succeed in easing inflation, the gold prices could fall. But the Fed’s tools to control inflation are proving ineffective amid external factors beyond its control. These factors include the Russia-Ukraine war, supply chain shocks, and commodity prices.
“I think that events of the last few months have raised the degree of difficulty, created great challenges. And again, the answer to the question, can we still do it? There’s a much bigger chance now that it will depend on factors that we don’t control. Fluctuations and spikes in commodity prices could wind up taking that option out of our hands.”Jerome Powell
How gold performs in stagflation
While the current scenario is bearish for gold, it could become bullish if the U.S. economy falls into stagflation and later into recession. In the past major episode of stagflation, the gold price surged six-fold from US$100 in 1976 to about US$700 per ounce in 1980, while the spread between annual inflation and yearly GDP growth exceeded a double-digit rate.
In 1979, Paul Volcker became the Fed chair and increased interest rates to control inflation, putting gold in bear territory. Economists compare the current scenario to that of the 1970s, and Powell has started rate hikes early.
Can gold protect your portfolio from stagflation?
Here is the dilemma. Can gold protect your portfolio from stagflation or looming recession? It depends on how the external factors play out. If there is stagflation, the dollar could weaken, and gold could rise. And if there is any black swan event like another wave of pandemic or major crisis, gold could shoot up within days.
Even today, gold is an alternative asset class and holds an exchange value beyond boundaries. Although it may not be a good investment in economic prosperity, it is an asset everyone should have to dilute the impact of a crisis. If you have no investment in gold, now is the time to get exposure to the yellow metal.
It is a good time to buy Barrick Gold (TSX:ABX)(NYSE:GOLD) stock, as it trades 20% below its April high. The stock has a strong history of paying dividends every year since 1987. When gold price surges, the stock jumps at an accelerated rate and pays special dividends.