Undeniable green shoots (2)

I return to this subject to clarify what I think is driving commodity prices. There's been lots of back-and-forth on this in the commentary. People who are skeptical that rising prices signal a recovering economy invariably allege that speculators, fueled by easy money, are driving prices higher, and so rising prices tell us nothing about the health of the economy but a lot about how easy the Fed is and how much inflation (ultimately an economy-killer) we'll have going forward. I've countered that it is difficult for speculators to amass sufficient stockpiles of a lot of the commodities contained in this index. After some brief research I even uncovered data showing that inventories of copper at the London metals exchanges have dropped significantly in recent months even as prices have risen.

In any event, here's how I would describe what has happened with commodity prices:

Global demand suddenly collapsed around September, as fears of a collapse of the global banking system brought markets to a halt and fearful consumers stopped spending on nonessential items. To make matters worse, banks stopped making letters of credit, and that shut down global trade. The global economy basically hit an air pocket as demand fell off a cliff. Producers soon found themselves with rising inventories as demand fell, and so they cut back production and prices fell. They cut production by a lot, fearful that the global economy was going into a depression. Early this year things started to normalize and demand stopped falling. World trade resumed after banks once again figured out how to write letters of credit. Demand proved to be stronger than everyone had feared. Production of commodities was slow to react as inventories began to drop, so prices started to rise. Higher prices today are surely encouraging commodity producers to ramp up production. Sooner or later production will rise enough to keep prices from rising to the stratosphere. Commodity speculation has likely played a role in rising prices in the past month or so, since confidence has returned, equity prices have boomed, but the Fed has yet to take steps to reverse its liquidity injections, thus creating rising inflation expectations.

I say again that rising commodity prices are an excellent indication that things are getting back to normal, and that growth is returning. Easy money may drive prices into another bubble, but if so we are still in the early stages. The important thing is that demand is back and production is undoubtedly ramping up in response to higher prices.