COLUMN - Easy money will keep pressure on commodities: John Kemp

Tue Apr 5, 2011 8:20pm IST

A money changer shows some one-hundred U.S. dollar bills at an exchange booth in Tokyo November 8, 2010. REUTERS/Issei Kato/Files

A money changer shows some one-hundred U.S. dollar bills at an exchange booth in Tokyo November 8, 2010.

Credit: Reuters/Issei Kato/Files

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-- John Kemp is a Reuters market analyst. The views expressed are his own --

By John Kemp

LONDON (Reuters) - Fed Chairman Ben Bernanke thinks the increase in inflation will be transitory and is being driven by price increases for oil and food linked to "global supply and demand conditions".

He forecast these prices "will eventually stabilise" but promised the central bank would respond if his prediction was wrong and inflation begins to make strong gains.

The remarks were made in an unscripted question and answer session at the Federal Reserve Bank of Atlanta, reported in the Wall Street Journal ("Bernanke plays down threats of inflation").

It is the clearest statement yet of the chairman's thinking about commodities, inflation and the central bank's response.

But the Fed has provided no explanation about why it thinks commodity prices will stabilise and thus ease upward pressure on prices more generally. While it is possible commodity prices will stop rising of their own accord, it is not likely.

RUNNING THE ENGINE TOO HOT

Sharp rises in food and fuel prices are being driven by a combination of supply problems (crop failures, political unrest); increasing consumption in emerging markets; and investors' expectations demand will continue to grow strongly for at least the next two years, in part due to highly supportive policy.

While inventories and spare production capacity in oil and many other commodities are ample at present, future demand growth amid supply constraints is expected to work down the cushion of spare capacity and stocks over the next 24 months, keeping prices on a generally upward trajectory.

Bernanke thinks commodity prices will eventually stabilise but it is not clear why. Political unrest across the Middle East, North Africa and West Africa may eventually burn itself out but the resulting political risk premium will linger. Future supply shocks (droughts, floods and other crop failures) are inevitable.

Pressure from the demand-side will continue. Rapidly rising world consumption has left many commodity markets with only a relatively thin margin of spare capacity and vulnerable to inevitable supply disruptions. Commodity demand is simply outstripping assured supply.

As commodity markets become increasingly financialised and forward-looking they have become progressively more sensitive to estimates of growth prospects over the medium term (2-3 years) and fears about the potential for any supply disruptions over the period.

Bernanke gave no reason to think commodity demand will grow any more slowly in the next three years so there is unlikely to be a let up in price increases. In fact, contrary to the Fed chairman, past experience suggests upward pressure on prices will intensify as the expansion matures.

It is not clear why he thinks pressure on resources and inflation will decline as the expansion in the United States and around the world matures and the margin of spare capacity across all industrial sectors (including manufacturing) falls. It is more likely inflationary pressures will worsen as the cycle progresses.

I can see no reason to expect commodity prices and inflation to fall back in the next two years. In fact inflation will likely increase unless the policy environment changes.

CONSUMPTION GROWTH WILL SLOW

Bernanke cannot point to a single additional oil field or mine that will ease supply constraints. While record plantings in the United States might help ease pressure on food prices, the global farm production system will remain vulnerable to adverse weather conditions and highly variable yields.

Price increases should eventually bring forth some increase in production capacity, but not for 3-5 years or more.

In the meantime, soaring food and fuel prices are a direct consequence of the Fed and other major central banks trying to operate the global economy beyond its natural supply-side capacity. For as long as the policy persists, inflation will continue to accelerate.

Commodity demand is much more sensitive to changes in income than prices. So restraining price increases will require a shift to a slower growth path for the global economy.

Prices will eventually stabilise, even fall, but only when demand growth shifts down to a more sustainable path. Either monetary policy becomes less stimulative, or price increases cut so deeply into real incomes and business margins the economy starts to falter of its own accord and policymakers conclude they cannot offset the recessionary forces by offering more stimulus.

FED ASSUMES A CAN OPENER

Some policymakers and commentators prefer to blame rising commodity prices and inflation on China's refusal to allow the yuan to rise.

In this view, the Fed is setting the correct monetary policy for the United States, but it is being transmitted around the world via a system of semi-fixed exchange rates to some of the larger emerging markets where it is often inappropriate. The solution is for China to allow its currency to appreciate faster.

There are two fundamental problems with this argument.

First, revaluation of the yuan and devaluation of the dollar is almost certain to make the global inflation problem worse. It would put upward pressure on dollar commodity prices. The dollar's overvaluation has so far masked the extent of the inflation problem in the United States and other advanced economies. If the dollar is devalued, interest rates would have to rise significantly to offset the inflationary impact.

Second, supporters of the Fed and critics of China are guilty of making what might be termed the "assume a can-opener" mistake.

In various forms, the famous joke highlighting economists' lack of realism has a physicist, a chemist and an economist stranded on a desert island pondering how to open a washed up can of beans. The physicist proposes smashing the can open on a rock. The chemist advises soaking it in salt water to erode it. The economist says merely "Let's assume we have a can opener".

The Fed's ultra-loose monetary policy would indeed be the correct response in a world of fully flexible exchange rates. It is one reason Fed Vice-Chairman Janet Yellen has made an impassioned plea for countries to maintain flexible currencies so central banks are free to pursue independent monetary policies.

But the Fed is not living in a world of flexible exchange rates. It might like a can opener, but unfortunately it doesn't have one. In a world of semi-fixed exchange rates, ultra-low interest rates and stimulative policies in the United States and the other advanced economies are resulting in excess global demand and rising commodity-led inflation.

Appreciating the yuan would redistribute demand from one country to another (away from China and towards the United States) but would not solve the fundamental problem that on global level there is too much demand chasing too little supply.

Commodity prices and inflation will only stabilise when monetary policies around the world shift to a less expansionary phase.

But the Fed remains determined to ignore rising food and fuel prices and maintain a highly accommodative stance for an extended period. Global growth will continue to outstrip available supply in the short term leading to a further build up of inflationary pressures.

With the Fed's course apparently set, there is no reason to expect commodity prices will stabilise any time soon, until policy tightens or the global economy begins to crack under the burden of rising oil.

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