Tuesday, February 23, 2010
This chart shows the relation between gold prices and the spot prices of non-energy industrial commodities (burlap, butter, cocoa beans, copper scrap, corn, cotton, hides, hogs, lard, lead scrap, print cloth, rosin, rubber, soybean oil, steel scrap, steers, sugar, tallow, tin, wheat, wool tops, zinc). The correlation between the two is pretty impressive, and it's also noteworthy that gold prices tend to lead commodity prices by as much as a year or two.
The huge current gap between gold and commodity prices is just screaming to be addressed. Are we on the cusp of a major upturn in commodity prices? What is driving these prices higher: inflationary monetary policy or stronger global growth, or both? I don't have solid answers, but the surge in gold prices in recent years, coming at a time when virtually all major central banks are pursuing accommodative money policy, suggests to me that the monetary explanation for higher commodity prices is the dominant one, though that certainly does not preclude increasing global demand as a factor. At the very least, as I mentioned in a recent post, I think this means deflation is dead. (The one-month drop in the January Core CPI notwithstanding; the big increases in PPI inflation at the crude and intermediate levels are pretty impressive, and a portent that inflation pressures will eventually make it to the consumer level.)
If deflation is dead and inflation is alive and well, as this chart suggests, then the downside risks to the economy are much less scary than conventional wisdom holds. It's my sense that there are a lot of people—including Bernanke and other Fed governors—who are very worried about the possibility of Japanese-style deflation and weak economic growth plaguing the U.S. economy for years to come. Those concerns are built on Phillips Curve thinking, which holds that when an economy is operating at a level significantly below its potential, then there are persistent downward pressures on overall prices. Downward price pressure—deflation—in turn saps consumer demand, or so the thinking goes, because consumers can make money by simply not spending it.
These concerns fail to account for the fact that the monetary fundamentals in Japan and the U.S. are completely different, and offer a better explanation of why deflation has been a persistent problem for the Japanese. The Bank of Japan has been pursuing a deflationary monetary policy for decades, as reflected in the fact that the yen has been appreciating against most currencies for the past 40 years, whereas the dollar is close to all-time lows against a basket of currencies. Moreover, U.S. demographics ensure healthy population growth for the foreseeable future, whereas Japan is now experiencing a shrinking workforce and a rapidly aging population.
To be sure, inflation is not a friend to economic growth. Inflationary psychology diverts much of the economy's energy to price speculation, rather than to jobs-creating investment. Plus, too much inflation inevitably leads to economic weakness, especially when central banks are forced to tighten monetary policy to bring inflation down.
But in the current environment I think it is the absence of deflation risk that is the important thing to focus on. If you truncate the deflationary side of an expected distribution of returns, you boost expected returns significantly. The disappearance of deflationary risk means the Fed will be less likely to be too easy for too long. The greater likelihood of inflation means consumers are less likely to continue hoarding money; money velocity is thus likely to increase, and this will help drive growth going forward.
It's very unfortunate that we have to be worrying about these issues in the first place. It would be far better to have had a stable monetary policy and stable (and low) inflation expectations over the past few decades. But we, like the Fed, are stuck with the consequences of past monetary actions and errors, and we need to deal with them. The situation we are faced with today is not one of deflationary risk, and it's important to understand that.
Posted by Scott Grannis at 2:31 PM