Inflation, weak dollar to boost long-term gold tags

The likely depreciation in dollar and rising global inflation could boost gold's appeal as an anti-inflationary hedge, a study by the World Gold Council said. To combat inflation in the long-term investors should steadily divert their resources to the yellow metal, it said.

The study conducted by Eric J Levin of the University of Glasgow and Robert E Wright of the University of Strathclyde, gives an contour of the long-term and short-term determinants of gold.

"If gold is a long-run hedge against inflation, and if it is true that real dollar depreciation against other currencies is inevitable, US wealth holders should profit from holding gold during this period," the study said.

Dollar depreciation will lower the price of gold to investors outside US, which will in turn increase demand and raise the US dollar price of yellow metal, it said.

In December 2005, gold prices broke the $500 an ounce barrier for the first time since 1981, when gold tested a peak of $850 an ounce.

By mid-January prices tested $548 and surged to $730 an ounce in May. Currently, gold is quoted at $625 an ounce.

Short run factors: In the short-term, gold prices will be largely determined by supply-demand and other stochastic factors, it said. The main factor that would affect supply in the short run will be leasing of gold by central banks across the world.

"Gold producers (mines) can implicitly supply their customers by leasing gold from central bank gold reserves, through a bullion bank intermediary as well as extracting it from their mines," it said. The study said demand for the metal falls under two categories""use demand and asset demand.

Use demand refers to demand for jewellery, medals, and electrical components among others, while asset demand refers to demand for gold as an investment option.

However, asset demand depends on slew of macro economic factors-returns from other assets (bonds, stocks), dollar exchange rates, and inflationary expectations among others.

Long run determinants: In the long run, gold prices are likely to be determined by inflation.Gold's appeal as an anti-inflationary hedge will increase its demand and will eventually lead to a spurt in prices.

Price of gold in the long run is expected to rise in proportion to the rate of inflation.

"In the long run gold price is related to the marginal cost of extraction (of mines) and if the cost of production rises at the rate of inflation, the price of gold will rise at the same rate," it said.

Marginal cost of extraction is the additional cost mines incur to produce an extra ounce of gold.