Supply-Side Forum

THE GOLD VOLATILITY MODEL (GVM)

Ed Breen, January 6, 2008 (© 2008)

The Gold Volatility Model predicts the percent year on year change in the Core PCE six months in advance. The econometric methods and the rational for the model were explained in a paper that was written by Sean P. Breen that was published by Polyconomics, Inc. in December 2005. Sean Breen worked for Polyconomics during the summer of 2004. He developed the model and wrote the paper in the fall of 2005, during his senior year at Middlebury College. The paper was written to analyze the significance of gold price as a possible tool in monetary policy.

While Supply-Siders have argued that gold price predicts both inflationary and deflationary tendencies in monetary policy, there has been no serious econometric study that demonstrated the validity of the Supply-Side position. Consequently, during the past decade the use of gold as a monetary indicator has fallen out of favor. Moreover, recent academic research analyzing this issue has indicated that gold and other ‘commodity basket’ targets may be ineffective, or perhaps even detrimental as a monetary tool. The conclusion of GVM paper, however, is that the recent literature is flawed in that the question has been examined from the wrong perspective. Instead of looking at only the price of gold, the GVM examines the importance of movements in the price of gold. We use gold volatility and a “gold-spread” (measured as the percent difference between spot gold and a moving average) as the measure of gold movement. Through testing, we find that movements in the price of gold, lagged by 6-months, are cointegrated with both the CPI and PCE Deflator, indicating they move together over time. More importantly, because the variables are lagged by 6-months, gold movement can be said to predict movement in consumer prices as measured by the CPI or the PCE Deflator. Finally, these results are supported by ARIMA analysis, correcting both for serial autocorrelation in some variables and heteroskedasticity in one of the models. In every case, our models are significant to a high degree of confidence, while in the CPI Model only gold volatility remained significant in the corrected model. With regard to the Core PCE Deflator model every gold variable is individually significant. From these results, we conclude that gold should not only play a role in monetary policy, but when considered correctly it becomes an indispensable tool of analysis.

The GVM predictions for next six months and the record of prediction for the past 30 years are listed below.

The Detailed Data, Going Back to 1975

The following table and graph show the results generated by the model as applied to data going back to 1975, a time right in the middle of the "Great Inflation" of the 1970's.