-- John Kemp is a Reuters market analyst. This is the second of two articles. The views expressed are his own --
By John Kemp
LONDON (Reuters) - The last and most important line of defence for central bankers and economists trying to disclaim a link between monetary policy and soaring commodity prices has been to argue that the effect is probably only temporary.
Food and fuel price increases are portrayed as a one-off adjustment in response to a series of discrete and unrepeatable shocks rather than an ongoing process of inflation that signals excess demand. While they will push up the headline rate of inflation, the effect is expected to be transitory, according to the Federal Open Market Committee.
Once food and fuel prices level off, headline inflation will converge back to the core rate. This thinking permeates the Fed's thinking, and is central to the projections of the Bank of England. It was also recently articulated by Nobel Laureate Paul Krugman in a blog for the New York Times.
Much the same argument was used three years ago in February 2008, when then Fed Vice-Chairman Don Kohn promised that inflation would soon come down and argued, "This projection assumes that energy and other commodity prices will level out, as suggested by the futures markets." This was before the oil market began its final ascent to $147 per barrel. here Echoing this, current Fed Vice-Chairman Janet Yellen said last month, "The current configuration of quotes on futures contracts -- which can serve as a reasonable benchmark in gauging the outlook for commodity prices -- suggests that these prices will roughly stabilise near current levels or even decline in some cases."
Krugman endorsed this thinking: "The idea is that even if the recent commodity price rise is permanent, as long as it levels off it will lead only to a temporary bulge in broader inflation. And the appropriate response of the Fed is to keep calm and carry on." here
CIRCULAR THINKING PROBLEM
But is this argument correct or an example of circular reasoning? Ignore for a moment the question about whether it is possible to extract useful predictions about future cash prices from futures contracts, which is very questionable.
The argument seems to run as follows: (1) commodity prices are determined by micro supply and demand factors rather than macroeconomic policy; (2) food and fuel price rises are one-off responses to a specific supply and demand situation rather than an ongoing process; (3) prices will eventually level out irrespective of policy, and when they do so the impact will drop out of inflation numbers; therefore (4) the Fed need not respond to rising prices because they do not signal excess demand.
The conclusion implicitly assumes the premise.
The counter-argument is that commodity prices are rising because of excess aggregate demand in the global economy and excessively loose monetary conditions transmitted from the United States to the rest of the world through the system of semi-fixed exchange rates.
Excess demand is showing up where the bottleneck is tightest, which at the moment is commodities rather than manufacturing or labour markets. By the time the Fed and other central banks have stimulated demand enough to close the gap in labour and manufacturing markets, pressure on commodities will be intense and prices will be surging.
This argument is at least as plausible as the ones advanced by Fed Chairman Ben Bernanke, Yellen, New York Fed President Dudley, Krugman and others. But if it is true, then increases in commodity prices are part of an ongoing process rather than a one-off adjustment. So long as policy remains stimulative, commodity prices will continue to rise, not level off.
In fact that is precisely what many hedge funds are expecting. Money managers have been running record long positions in crude oil and many other commodities, according to reports from the U.S. Commodity Futures Trading Commission.
MARKETS POINT TO HIGHER PRICES
Contra Yellen, who thinks the futures market is predicting prices will level off around current levels, at least half the market thinks prices will rise further. These are the very sophisticated financial investors whose hyper-rational expectations are central to theories such as those of Britain's FSA and of a host of research economists.
The "smart money" thinks commodity prices will continue rising in the medium term, promising no let-up in headline inflation.
Who is to say that the smart money is wrong? Given the deep cyclical nature of commodity markets, it would be surprising if commodity prices fell significantly as the global economic expansion matured. It is much more likely they will continue to increase if global central banks try to keep the economy on its present course.
The more the Fed and other central banks try to (over)-stimulate the global economy and make it grow faster than the available supply of raw materials allows, the longer and further commodity prices are set to rise, until rising input costs finally choke off the recovery.
In this sense, rising commodity prices are as much a product of monetary policy as the rise in equity values and the fall in the dollar.
The Fed is focusing on the wrong "output gap". It should be looking at the output gap globally and in commodity markets, rather than in the United States and the labour market and manufacturing.
IMPRISONED BY THE PAST
On the question of monetary policy's role in rising commodity prices, popular opinion is basically correct, and the economics and central banking establishment is wrong.
While central bankers and Keynesian economists are willing to embrace the importance of animal spirits in guiding monetary and macroeconomic policy, they cling to a strangely classical theory of commodity pricing, which leaves them largely unable to explain what is happening in the real world.
It was John Maynard Keynes who remarked, "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood � Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist."
In this instance, progressive thinking about macroeconomic policy has been strangely allied with conservative and unrealistic theories about raw material pricing that cannot explain why prices have risen so far so quickly and are contributing to serious errors in forecasting and policy.
It is time for a rethink, with more emphasis on the real world and less on abstract theory.
(Editing by Jane Baird)
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