Scourge of commodity inflation returns
By Hossein Askari and Noureddine Krichene
Commodity price inflation during 2001-2008 was about the highest in living
memory - rising by 25% per year during January 2001 to August 2007 and
accelerating to 65% per year from then to July 2008 (see chart 1).
From 2001 lows to their peaks in 2008, gold prices rose from US$257 per ounce
to $1,035; crude oil from $17 per barrel to $148; copper from $0.62 per pound
to $4.98; corn from $1.93 per bushel to $9.60; wheat from $2.42 per bushel to
$13.18; rice from $170 per tonne to $1,039; and soybeans from $4.22 per bushel
to $16.36. In the same period, the US dollar, the currency of commodity price
denomination, fell from $0.84 per euro in 2001 to $1.60.
As staple commodity prices shattered records in 2007-2008, the
less fortunate the world over struggled through food and energy crises. These
led to a food summit in Rome in June 2008 and an energy summit in Jeddah the
same month. Left unchecked, commodity price inflation peaked in June-July 2008,
and in the process disrupted a number of key sectors, squeezed consumer real
spending, and precipitated the deepest recession since the Great
Depression.
Central banks that issued reserve currencies have simply ignored commodity
price inflation and have denied any link between that and monetary policy. They
ignored food and energy price gains and considered only "core" inflation as a
guide to policy making.
The fact is that commodity price inflation is transmitted directly to food and
energy prices. For instance, a rise in crude oil price is transmitted
instantaneously to consumers through immediate rises in prices at the pump. In
the same vein, a rise in the price of rice is transmitted immediately to
consumers through an immediate increase in retail prices for rice.
However, a rise in crude oil or in rice prices would have much less noticeable
effect on the prices of video games and toys that are part of the core
inflation index. Not surprisingly, while the prices of staple food products
have tripled, quadrupled, and quintupled, the core inflation remained unchanged
at 1% to 2% during 2001-2008, as central bankers were congratulating each other
for eradicating inflation!
Commodity price inflation was a delayed response to an excessively loose
monetary policy during 2001-2009 by central banks. Interest rates were forced
to record low levels, turning largely negative in real terms (see chart
2).
Johan Gustaf Knut Wicksell (1898) long ago analyzed the relationship between
interest rates and commodity price inflation. Low interest rates may lead to a
rise in commodity prices and vice-versa. Commodity price inflation (chart 1)
displayed a classical Wicksellian cumulative process. It kept rising as
interest rates were kept depressed at low levels.
In contrast to modern central banks, central banks in the 19th century
considered commodity price inflation a policy guide. They restrained money
policy when commodity price inflation rose to avoid a depreciation of money as
well as monetary disturbances that would disrupt real economic activity.
Totally disregarding commodity price inflation and simply blaming it on China,
India, and oil producers, the Fed decided to accelerate monetary expansion in
August 2007 at a time commodity price inflation was in the double digit range
at 25% a year. The Fed's move exacerbated inflation, pushed it to 65% a year,
and sent the world economy spiraling downwards following disruptive effects of
explosive oil and food prices.
John Maynard Keynes likened commodity and asset markets to a casino and
introduced the concept of speculative demand for money to support speculative
activities. Stock exchanges, futures markets, commodity exchanges, and exchange
markets are dominated by speculators. Speculators included defunct firms such
as Enron, Metallgesellschaft AG, Tyco, and WorldCom as well as the failed hedge
fund Long-Term Capital Management, which were all wiped out by excessive
risk-taking strategies and "sophisticated" speculative engineering.
Speculators also include individuals who place orders through brokers and
dealers. Financial engineering and the multiplication of derivatives have made
speculation more sophisticated and extended its breadth. The new form of
speculation has been dubbed as the "financialization of commodity and asset
markets". Speculators are only after price gains.
A speculator may buy oil from a producer or a trader at $65 per barrel and sell
it to a refiner or to another trader at $75, making a gain of $10 per barrel to
be born by the final consumer. Although a speculator does not make any
investment in oil exploration or in offshore drilling, he can make large gains
by simply betting and trading on exchange markets.
Speculators may speculate on the downside of the market through short-selling.
In line with the "market efficiency hypothesis", speculators use all available
information in the market. Any piece of news can cause jumps in speculative
prices, making these prices highly volatile. The speculators also make bets, as
in a horse race, on expected prices of stocks, commodities, or exchange rates.
A general and persistent speculative trend, such as the one observed in housing
or commodity markets during 2001-2008, is difficult to sustain without a cheap
monetary policy. Abundant liquidity and very low interest rates make the cost
of financing margin requirement very low and thus encourage speculation.
Moreover, very low interest rates boost aggregate demand, including the demand
for commodities. For instance, low interest rates and abundant liquidity boost
demand for stocks, crude oil, food, and for raw materials such as copper. And
speculation can become feverish in buoyant markets.
High inflation is often followed by deflation, as asset bubbles burst and are
followed by a free fall in asset prices. In large part because speculation
helps to push prices out of line with market fundamentals and after asset
prices become over inflated, an adjustment to market fundamentals will in turn
lead to a sharp drop in asset prices, with devastating losses to asset holders.
For instance, pension funds suffered large losses when the stock market crashed
in November 2008, and banks suffered big losses when mortgage loans fell in
default and housing prices collapsed.
After peaking in June-July 2008, commodity prices went into a free fall during
August-December 2008 (see chart 1 above), despite an excessively loose monetary
policy. Two main factors explain the decline. First, unprecedented commodity
price inflation brought about a severe economic recession and a significant
drop in real demand for commodities. Hence, a main driver for prices, namely
rising real demand, vanished.
Second, the financial crisis caused drastic losses for hedge funds and mutual
funds that held short-term liabilities and commercial papers of failed banks.
There was a run on speculative funds. Investors pulled their money from hedge,
mutual and equity funds, especially when the Primary Reserve Fund broke the
buck (that is, money market deposits fell below par value) and sought safety in
Treasury bills and deposits at safe banks. A large amount of speculative
liquidity was either lost or converted into risk-free treasury bonds and bills.
Hence, the de-leveraging process dried up liquidity that fueled speculation and
precipitated a free fall in stock and commodity prices.
Since March 2009, a highly expansionary monetary policy combined with record
fiscal expansion has provided a powerful impetus to speculation and overwhelmed
speculators with liquidity. Despite deep economic recession and rising
unemployment that has reached 10% of the labor force in leading industrial
countries, the All Commodities Price Index recovered by 31% from its bottom in
February 2009, or at an annual rate of 75%, and US stock prices rebounded by
32% during March-July 2009.
Despite a stagnating oil demand at 83 million barrels per day, oil prices more
than doubled, rising from a low of $35 per barrel in December 2008 to a high of
$76 in August 2009. Many staple commodity prices are back on the upward run.
The Food and Agriculture Organization food price index shows that food prices,
in spite of the fall recorded in late 2008, are rising again and remain far
above their 2006 level. Hence, abundant liquidity pumped by major central banks
has found its way directly into commodity and stock markets speculation. Even
though real activity was contracting, asset and commodity prices were bid up in
an inflationary frenzy as a result of excess liquidity.
With the reappointment of Ben Bernanke as the Fed chairman, speculators around
the world feel re-assured there will be a continuation of loose monetary
policy, in the form of near-zero interest rates and abundant liquidity.
Speculative fever could regain the strength it had in the period before July
2008 and drive commodity prices to higher and higher levels.
The Wicksellian cumulative process could be evolving again. Gold prices are now
past $1,000 per once. Similarly, oil prices are more likely to rise toward $80
per barrel rather than retreat to $60. The most vulnerable prices are those of
oil and food as demand for these products is inelastic. Food and an energy
price inflation would erode workers' and pensioners' real incomes and
redistribute wealth in favor of speculators and borrowers.
As core inflation remains low - in the 1%-2% range and is insensitive to a
two-digit commodity inflation and rapid depreciation of the US dollar, as well
as other reserve currencies in terms of commodities - central banks will
continue to be oblivious to commodity price inflation and will maintain
dangerously loose monetary policy while pretending that they had been
successful in eliminating inflation!
If economic recovery takes place, then a new force will exacerbate speculative
fever. Commodity price inflation may accelerate and turn into a hyperinflation.
Under this scenario, the world may have to again live with the same food and
energy nightmares of 2007-2008.
The poor would suffer further losses in food intake. Malnutrition would spread.
Commodity price inflation would remain unchecked, as in the past, until it
became disruptive and brought the real economy to a standstill. It would appear
that major central banks have made commodity markets highly unstable and have
created an inflationary and speculative environment that will continue to
depress real economic growth and social welfare.
Hossein Askari is professor of international business and international
affairs at George Washington University. Noureddine Krichene is an
economist at the International Monetary Fund and a former advisor, Islamic
Development Bank, Jeddah.
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