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DESPITE gold's reputation as a hedge against inflation, investing in gold can be equally effective in reducing an investor's risk profile during periods of deflation, a leading metals market analyst has said.

"Gold's purchasing power is more likely to increase in deflationary periods than during inflationary eras," says Rhona O'Connell, senior analyst at precious metals consultancy Thomson Reuters GFMS, writing in the latest GFMS newsletter.

"Although it may seem counter-intuitive, gold can be as effective a hedge against deflation as against inflation."

Exiting a gold investment in advance of a period of deflation could, she suggests, leave an investor holding a riskier portfolio.

"In the short term," writes O'Connell, "[market] participants are concerned that any or all of the United States, Europe or China could be sailing into deflationary headwinds. History suggests that to sell gold ahead of such a development would be counter to the likely price outlook, as well raising one's investment risk profile rather than reducing it, especially as a deflationary environment would be likely to undermine equities, while keeping bond yields low."

O'Connell cites Roy Jastram's work 'The Golden Constant', which looked at a series of inflationary and deflationary periods on both sides of the Atlantic, going back as far as seventeenth century England.

"In each of the four deflationary periods since the 17th century in England, gold has increased its purchasing power, by between 42% (1658-1669) and 251% (1920-1933)," writes O'Connell.

"In the United States, there have been three recorded deflationary periods – and gold increased its purchasing power in each of them, by between 44% (1929- 1933) and 100% (1814-1830)."

Today's market conditions, she adds, make a case for investing in gold ahead of a potential deflationary scenario.

"The stress in the banking sector," writes O'Connell, "and gold's historical performance during deflationary phases add weight to the argument that any deflationary fears should underpin gold prices."

In 2011, research firm Oxford Economics modeled the impact of various deflation and inflation scenarios, finding that gold investment performed well in both deflation and high inflation. The Oxford Economics report can be downloaded from the World Gold Council.

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