March 5, 2008
Life in a tough world of high commodity prices
By Martin Wolf
Soaring commodity prices, rising headline inflation and weakening economic growth: for those whose memories stretch back to the 1970s, this combination brings painful memories. It reminds them of the mistakes made by the central banks that accommodated the upsurge in inflationary expectations rather than contained them. Inflation was finally brought back under control in the early 1980s. But the costs of letting it escape were huge. Could we be making the same mistakes again?
In the US, headline consumer price inflation was 4.3 per cent in the year to January. In the eurozone, it was 3.1 per cent in the year to December 2007. In both cases, there was a gap – in the case of the US, a huge gap – between the headline rate and the “core” rate, which strips out volatile prices of energy and food.
If this were a temporary deviation, one would ignore it. But it has been continuing for years, particularly in the US (see chart). A cynical observer might well conclude that the Federal Reserve threw caution to the wind years ago. That is what Arthur Burns, then Fed chairman, did in the early 1970s, under pressure from Richard Nixon, then president. Has that been happening again in recent years? The question is surely a fair one.
Continue reading Martin Wolf’s column here, and read comment from forum members and contributors below.
Philip K. Verleger, Jr: (Guest commenter) The current surge in commodity prices reflects a reversion in investor thinking to conditions that existed more than twenty years ago. Faith has been lost in central bank willingness to maintain a stable price level. Hard assets are now more valued. In a similar situation in late 1979 investors, seeking to own hard assets or claims on hard assets, bid the price of silver up ten fold.
Disciplined central bank polices since 1980 had made the silver crisis and fear of inflation history. Ben Bernanke’s 1997 Brookings paper as well as his 2004 speech at Dalton, Georgia (as a member of the Fed) explained how and why central bankers had resolved the issue. The rigorous and steady implementation of good policies reduced the precautionary demand for commodities on the part of investors. (The term “precautionary demand ” is borrowed from Jeffery Williams great book “The Economic Function of Futures Markets.”)
It appears that this new approach to markets has now been abandoned.. Chairman Bernanke’s capitulation on inflation last week has ignited a rush of cash into commodities, particularly into funds of the GSCI or Dow Jones/AGI variety. Investors are seeking paper assets that have claims on real commodities. Last week CALPERS announced it was increasing its investment to $7 billion in these instruments. It will, in effect, put more than half its assets in oil.
The increased demand must push prices higher. I do a weekly calculation of the amount invested in these indices. One can get a rough approximation through data published by the CFTC. As of last Friday the amounts invested were between 220 and 250 billion, depending on the ay one calculates the weights. The new moneys coming from CALPERS and other pension funds will , no doubt send prices up - probably significantly. Hedge funds can be expected to add to the upward pressure on prices. The problem is made worse by the fact that those who own physical assets are cutting their hedging activity, thereby reducing the supply of paper claims.
The current rise in prices has many similarities to the rise in silver prices. Then investors (speculators) bought silver to protect against inflation. Their buying lifted prices from $5/oz to $50/oz even though supply increased while demand from commercial consumers disinclined. Those in the industry complained that prices were out of touch with market fundamentals. The complaints were ignored.
Today, investors are buying oil and other hard assets, especially oil. Prices keep being pushed up because the supply of futures is declining even as demands rise. Those in the oil industry make the same complaint those in the silver industry made twenty years ago. More oil is available while demand seems to have dropped. The complaints are again ignored.
Oil exporting countries have chosen to watch from the sidelines. Exporters use pricing formulas linked to Brent and WTI. They do not offer buyers any bargains. As a result, buyers chose to buy less and cut stocks - even though the oil is on offer. Many buyers face a further constraint: money. The US FTC made a major effort to create an independent refining sector in the US. It succeeded. In Europe there are now more smaller refiners. The banks to these refiners are being less generous. Thus many firms that might buy cannot. Inventories go down and spot prices rise.
One of the world’s great authorities on the commodity markets, John Maynard Keynes would have enjoyed this cycle. Consumers will not. Absent unexpected changes, the world is in for a very nasty year of commodity inflation.
Philip K. Verleger, Jr is an academic, consultant and former US Treasury official. He is an expert in energy markets and pricing.
Posted by: Philip K Verleger Jr (Guest commenter) | March 5th, 2008 at 8:04 pm | Report this commentPaolo di Montorio-Veronese (guest): Inflation is always a monetary phenomenon as Milton Friedman said. The expansionary monetary policy of the last decade, during the so called “death of inflation” period, is crucial but we have to analyse carefully the catalysts.
(i) the U.S. is suffering asset deflation - not just in real estate but also in segments of the bond markets, including the USD2.6trn muni bond market due to “monoline” bond issuers and credit ratings - thus prompting further monetary easing (with current 6% probability of a 100bps cut and 94% probability of a 75bps cut on March 18).
(ii) the BRICs and more generally the non-OECD world - which generated the majority of global GDP growth in recent years - have resurgent inflation rates (witness China 7.9% in Feb.) prompting monetary policy tightening also in Australia, while the MidEast richer countries in the GCC are discussing a depeg from the dollar to ward off inflation (8% in UAE and 6.5% in Saudi). The demand from the non-OECD world is the main catalyst of the recent surge in commodities prices. It used to export deflation in manufactured goods (the WalMart effect), it is now exporting inflation in commodities prices (energy and food).
As soon as the credit crisis bottoms out (perhaps after the U.S. election ) the Fed will have no choice but to increase interest rates again to prevent the onset of permanently higher inflationary expectations and the tipping point for the world economy will be for OECD nations to avoid retrenching into protectionism, not just free trade and the WTO but also SWF investments and overall competition, including tax competition, with the non-OECD world.
Some OECD nations like the UK - that have increased public spending and budget deficit this decade during a benign world economy cycle, unlike its peers - will risk an acceleration of the depreciation of their currency, that has already moved 10% out of its hitherto stable trading range versus the Euro in the last 6 months. It might prompt the monetary policy to be more restrictive than expected, which would further slow GDP growth and reduce house prices, causing further currency depreciation, even in the event of a dollar rebound later this year.
Paolo di Montorio-Veronese is a macro-economist managing a hedge fund portfolio with a global macro analytical framework, currently short sub-prime and long commodities.
Posted by: Paolo di Montorio-Veronese | March 10th, 2008 at 9:48 am | Report this comment