Will Precious Metal Prices Drop as Inflation Cools?

Inflation Cools

After reaching a 40-year high of 9.1% in June 2022, inflation in the U.S. settled at just 2.4% last September as the Fed’s aggressive rate hikes started delivering the desired results. As inflation cools, investors who flocked to safe-haven assets like precious metals over the last few years are reassessing their options. Investors are looking for clues to determine if holding these assets could negatively impact their portfolios.

While the value of precious metals is closely tied to inflation, it is not the only determinant of precious metal prices. Understanding this complex relationship will help investors make more informed decisions.

Why Inflation Cools

Restrictive monetary policies, including rate hikes by the Federal Reserve, aided by reduced energy prices and stable consumer spending, have helped inflation to cool down in the United States. The Fed’s prudent interest rate management strategy has played a pivotal part in maintaining inflation. Between March 2022 and July 2023, the Federal Open Market Committee (FOMC) hiked the Fed Funds rate 11 times, bringing the benchmark policy rate from a near-zero level to a floor of 5.25%.

These aggressive rate hikes have curbed consumer spending, reduced money circulation, and discouraged businesses from investing, eventually leading to cooling inflation. Although inflation is cooling, data indicates that the total inflation rate since 2020 is still very high. Consumer prices have increased more than 20% since February 2020, thus reducing the dollar’s value by the same amount.

Stabilizing energy prices have also aided the Fed’s fight against inflation. On October 28, U.S. average gasoline prices dropped below $3/gallon. When gas prices go down, it creates a ripple effect across the economy, cooling inflation. In addition, the normalization of global supply chains has also played a part in curbing inflation.

How Inflation Affects Gold and Silver Prices

Empirical evidence suggests rising inflation causes the price of precious metals to increase because of a few reasons. The role of precious metals as a store of value often attracts investors to these assets during inflationary periods, resulting in robust demand for commodities such as gold and silver. Also, since gold and silver prices are quoted in U.S. dollars, the weakening value of the currency often leads to higher prices for these assets.

During stagflationary periods (high inflation, low economic growth, and high unemployment), both gold and silver have outperformed other major asset classes. Between 1973 and 2020, the U.S. has seen eight recessions, and gold has outperformed the S&P 500 Index during six of these recessionary periods. From six months before the start of the recession to six months after the end of the recession, gold has outperformed the stock market by a staggering 37%.

However, even when inflation cools down, the prices of precious metals are expected to remain stable or rise gradually in the foreseeable future. For gold, cooling inflation and lower interest rates may result in reduced demand temporarily. That said, given the cyclical nature of inflation and the risks faced by the global economy today, gold is likely to remain in high demand in the next few years. For silver, which is an industrial commodity, robust economic growth is good news, given that silver is used in many business sectors, such as electronics and renewable energy.

What Does ‘Hedge Against Inflation’ Mean?

An inflation hedge refers to an investment that intends to offset the negative impact of inflation. During inflationary periods, investors seek assets that can either maintain or accumulate their value in real terms. As inflation rises, the value of fiat currencies decreases, and precious metals are often viewed as an inflation hedge. Because of their scarcity and various industrial demands, gold and silver are considered popular choices as inflation hedges.

Even though gold may not have the ability to provide protection in the short term owing to its price volatility, in the long run, gold serves as a better hedge.

Inflation Isn’t The Only Factor

In addition to inflation, investors need to focus on a few other broad data points to evaluate the prospects for precious metals. While the general level of interest rates in an economy is a main consideration, geopolitical tensions need scrutiny as they tend to drive higher prices for precious metals since they are considered secure investments. In the wake of declining interest rates and rising geopolitical tensions, central banks across the world accumulate gold to help stabilize their economies. The diminishing role of the U.S. dollar as the global currency may also force investors to look toward precious metals to benefit from their safe-haven characteristics.

Will Inflation Continue To Cool?

Economists believe the Fed funds rate will be reduced further in the upcoming FOMC meetings, with the policy rate eventually reaching 4.25%-4.5% by December. With a total of 125 basis points cut through 2025, rates are expected to settle in the 3.00%-3.25% range by the end of 2025. Although inflation is likely to remain under control in the next few months, rate cuts may trigger another wave of inflation in 2025, paving the way for a rally in precious metal prices.

Conclusion

When inflation cools, it may result in a temporary decline in demand for precious metals. Still, this asset class will continue to play a major role in portfolio diversification in the foreseeable future because of its inflation-hedging characteristics and low correlation with other asset classes, such as stocks. Despite cooling inflation, investors should continue to maintain their exposure to precious metals in the wake of geopolitical tensions and the probability of an inflation spike in 2025.

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