Inflation is dropping. Here's how gold could be affected.

After more than a year of steep inflation, prices are finally showing signs of dropping. The latest Consumer Price Index showed that prices rose by an annual rate of 4% in May — down from the peak above 9% last June.

While lower prices are great news for consumers, the fluctuating inflation rate can also have implications for different investment types, including gold. Gold is typically seen as a hedge against inflation — and performs well when the value of the U.S. dollar moves down. 

But what does that mean for investors today, as inflation begins to cool? Whether you're already invested in gold or you're considering buying in, it's important to know how it may be affected by changes in inflation.

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How gold could be affected by lower inflation

There are a number of factors that can move the value of gold up or down at any given time, including economic data like inflation and how it influences the Federal Reserve's policy moves. 

Even though gold is a hedge against inflation, a lower inflation rate doesn't necessarily mean that gold prices will suffer, thanks to inflation's effect on rate hikes. Gold tends to move inversely to the U.S. dollar. When the Fed raise rates, it can raise the dollar's value and have the opposite effect on gold. As an example, gold's price dipped and then trended downward for several months when the Fed first began raising rates in 2022, according to price data from the World Gold Council.

In fact, some believe that if inflation were to remain elevated, the resulting Fed reaction could be a challenge for gold.

"The main headwind facing the market is oddly one of the things gold is purported to hedge: inflation," says Mel Mattison, CFP, financial services professional and consultant. "If inflation stays sticky, prompting the Fed to hold rates at higher levels for longer, this would likely strengthen the dollar and limit gold's upside." In other words, if the Fed continues to raise rates to offset inflation, that could prompt the dollar to gain value, and have a negative effect on gold prices. 

If the current trend toward lower inflation holds, on the other hand, it could mean the Fed is ready to loosen its policy — boosting gold prices. In fact, gold prices have already risen slightly in recent days largely based on unemployment and inflation data pointing to a Fed rate pause in June.

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Is now still a good time to invest in gold?

For long-term investors, these short-term movements in gold's price should be secondary to the benefits you can gain from gold over time.

Gold can make a solid investment option in any economy for investors looking to diversify their portfolios. Through changing economic conditions over a long investment timeline, gold can help you hedge against periods of inflation and weather downturns in other markets. An allocation of 5%-10% or less can be a good way to reap the benefits of gold while still benefiting from growth elsewhere, experts say.

That being said, there's also a few reasons gold could perform well in the shorter-term over the next few months. Some experts believe that gold could still break a new all-time high this year or next. And ongoing economic uncertainty, paired with concern over a potential recession, may increase gold's appeal for investors looking for a safe haven amid market volatility.

The bottom line

Inflation is just one economic factor that can affect the price of gold. In fact, gold's short-term value may be even more influenced by how the Fed reacts to lower inflation and other economic data when it decides its next interest rate move this week. Nevertheless, despite the resulting short-term changes in gold prices, the long-term benefits of gold still stand. 

The precious metal's appeal as a store of value and stable asset for diversifying your portfolio can make it worthwhile for those with longer-term investment goals. If you think gold could be right for you, consider speaking with an expert who can help guide you through your investment options today.