ANALYSIS - Recession fight may lift commods more than economy

NEW YORK Thu Mar 12, 2009 1:57pm IST

Gold bullion coins known as Krugerrands are pictured in the mint where they are manufactured in Midrand outside Johannesburg in this October 2008 file photo. Massive government debt issuance to fight the worst recession in many decades may push commodity prices higher without boosting industrial output. REUTERS/Siphiwe Sibeko

Gold bullion coins known as Krugerrands are pictured in the mint where they are manufactured in Midrand outside Johannesburg in this October 2008 file photo. Massive government debt issuance to fight the worst recession in many decades may push commodity prices higher without boosting industrial output.

Credit: Reuters/Siphiwe Sibeko

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NEW YORK (Reuters) - Massive government debt issuance to fight the worst recession in many decades may push commodity prices higher without boosting industrial output.

This stagflation scenario, feared by some economists, is not on the horizon yet. Since 2009 began, macroeconomic data suggests the industrialized world is experiencing zero inflation, even deflation, from falling prices of energy, cars, houses, stocks and non-government bonds.

But as central banks and governments print vast quantities of currencies to pay their way out of the downturn, the huge expansion of money supply may well stoke a major upsurge in inflation by early as 2010 as speculators rush back into commodity markets, economists caution.

Analysts expect U.S. Treasury debt issuance to hit $2.5 trillion this year alone, threatening to inundate the $6 trillion government debt market.

If speculators fuel a surge in commodity futures prices, this would make raw materials more expensive for industries already struggling with slow sales in a recession. It would also erode wealth for investors in bonds and fixed income products.

"The best bet is that we are going to experience some uncomfortable inflation in 2010 and 2011," said Bill Tedford, director of fixed income strategy at Stephens Capital Management in Little Rock, Arkansas.

He said the ultimate danger would be stagflation: a toxic combination of a stagnant or shrinking economy against a backdrop of rising prices.

"This would imply higher commodity prices without a corresponding rise in industrial activity," Tedford said.

A study of U.S. recession cycles shows commodity markets largely following the trend in equities and other global markets during periods of severe cash crunch.

The Reuters Jefferies-CRB index, a global commodities benchmark, did not show any remarkable climb during the recession of the early 1990s, caused by a surge in industrial production and manufacturing trade sales.

The index was also tame during the contraction that followed the bursting of the dotcom bubble, the Sept 2001 attacks against the United States and the Enron scandal.

The only recession periods when the RJ/CRB index spiked was during the 1973-75 and 1980-82 years, when the downturns were sparked by an escalation in oil prices.

Economists fear that record high prices of oil, metals and grains could prevent an economic recovery.

"With a ballooning money supply, stagnation with high inflation would be a more-significant risk," said Bruce McCain, chief investment strategist at Key Private Bank in Cleveland, Ohio.

"By definition, inflation is a 'generalized' rise in the price level, but actual price increases should be most intense for items in short supply and weakest for items where there is ample supply. Energy and other commodities were in short supply as the economy grew over the last year or so, and we think that will probably continue as world growth recovers," McCain said.

Crude oil prices have slumped to below $50 a barrel from a record high above $147 last summer as consumer demand tumbled.

Theresa Gusman, global head of commodities at DB Advisors, Deutsche Bank's institutional asset management business, said oil may go over $147 in coming years as the economy rebounds.

"I'm not saying that's going to happen in the next two years, but over time we will exceed that level," she said.

George M. Constantinides, Leo Melamed Professor of Finance at the Booth School of Business at the University of Chicago, concurs.

"Something drastic will have to happen with these low prices of oil because most oil-producing countries make their budgets on the assumption of oil prices being at least at $65," Constantinides said. "If this goes on, some of those countries may go bankrupt, and that will force the price back up."

If commodities soar again while the economy declines, there will be little recourse for central banks. For instance, the U.S. Federal Reserve has cut interest rates to practically zero and boosted money supply to fill stimulus packages meant to rescue teetering financial institutions and securities markets.

"I am sure that the Fed intends to reverse this stimulus before it causes inflation but, in this weak economic environment, I don't see how they can do that without prematurely forcing rates higher and thus further crippling the economy," said Stephens Capital's Tedford.

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