The link between commodity prices and monetary policy

As commodity prices continue to explore new high ground, I thought it appropriate to dig a bit deeper into the relationship between commodity prices and monetary policy. I've argued for a long time that rising commodity prices are a good sign of both economic growth and accommodative (e.g., inflationary) monetary policy, but I've never tried to say just which was the dominant factor. It may be a waste of time, but supply-siders like me simply can't shake our deeply held conviction that sensitive market prices are valuable and leading indicators of what's going on with monetary and fiscal policy—much better than official measures such as the CPI and GDP.

I frequently show a chart of the CRB Spot Commodity Index, an index I particularly like since it contains no energy prices and is representative of a broad range of basic commodities, many of which do not have associated futures contracts. The description below comes from the CRB website, and sheds further light on why the index is constructed as it is:

The Spot Market Price Index is a measure of price movements of 22 sensitive basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions. As such, it serves as one early indication of impending changes in business activity.

The commodities used are in most cases either raw materials or products close to the initial production stage which, as a result of daily trading in fairly large volume of standardization qualities, are particularly sensitive to factors affecting current and future economic forces and conditions. Highly fabricated commodities are not included for two reasons: (1) they embody relatively large fixed costs which fact causes them to react less quickly to changes in market conditions; and (2) they are less important as price determinants than the more basic commodities which are used throughout the producing economy.

The commodities included in the index are 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, and zinc. There are two primary sub-indices of the CRB Spot Index, both of which are shown in the charts above (Raw Industrials 59% and Foodstuffs 41%). As should be apparent, no matter how you slice it, commodity prices are rising strongly across the board these days, and reaching new all-time highs almost daily.

The folks at CRB built their indices on the assumption that basic commodity prices were good leading indicators of changes in economic activity. What they missed, however, was that commodities can also be good indicators of changes in the effective stance of monetary policy.

When almost all commodities are behaving in a similar fashion, Occam's Razor would suggest that there is probably some simple, common denominator working behind the scenes. How easy is it to believe that the producers of almost every single commodity out there are failing to keep up with the demand for their product at almost exactly the same time?

An easier explanation is that monetary policy is the common denominator. As partial proof, consider the chart below, which shows that there has been a relatively strong inverse correlation between the value of the dollar and commodity prices. Moreover, the dollar started weakening, and commodities started rallying, right around the time (late 2001) when the Fed began lowering interest rates in earnest: the Fed funds rate was slashed from 6.5% in late 2000 to 1.75% by late 2001, and was subsequently lowered to 1% from mid-2003 through mid-2004. Monetary policy was unquestionably easy for five years, even as the economy picked up steam beginning in the second half of 2003. It should not be surprising, therefore, that the dollar collapsed, and gold, commodity and housing prices soared—it was a classic example of what happens when a central bank dumps tons of excess money into the market. Money loses its value, and the price of things goes up.

Scott Sumner—a rising star in the economics profession, in my estimation—has penned some insightful comments on the subject of commodity prices and monetary policy, and he is one of the very few competent advocates of the theory that the Fed should target nominal GDP instead of inflation. His logic leads him to assert that the huge drop in commodity prices in 2008 was a clear sign that monetary policy was way too tight. I happen to agree with him, even though that is a very controversial opinion to have held at the time. Although I never said the Fed was way too tight in so many words, I argued in Oct. '08 that the Fed's massive balance sheet expansion was a good thing, since it was an appropriate response to the huge increase in money demand that was behind the huge decline in commodity prices. I went on to say that the Fed's quantitative easing should "at the very least forestall or reverse any deflationary tendencies that might result from the current financial crisis." And indeed, commodity prices hit bottom in early Dec. '08; subsequently, the consumer price index started to rise in early 2009, and by June '09 the economy began to recover. I think there is no question but that the Fed acted appropriately, even though, in retrospect, they probably should have acted sooner than they did. Their delay in implementing a massive easing program most likely exacerbated the decline in commodity prices and deepened the panic/recession.

I would further note that the dollar rose at the same time commodities collapsed in late 2008, with both actions the logical result of a sudden and effective shortage of money relative to the demand for money.

The next chart shows how gold and commodity prices have moved together, with gold tending to lead. This is more evidence that big swings in commodity prices can have a monetary origin. Why should gold move in sync with or in advance of commodities, if the movements of both weren't the result of an excess or a shortage of money?

What does all this mean? For one, the strong upward trend evident in both gold prices and commodity prices is a signal that quantitative easing is working. Working with a vengeance, in fact. If the significant fall in gold and commodities in late 2008 was a signal that the Fed was failing to provide enough liquidity to the market, then the even greater rise in gold and commodity prices over the past two years is telling us that the Fed has by now provided more than enough liquidity. QE2 should be halted and possibly reversed. The risk we face, however, is that the Fed will be very reluctant to reverse course, fearful that all the "slack" still out there continues to pose a deflationary threat to the economy. Plus, tightening monetary policy at a time when unemployment is still sky-high would be fraught with difficulties from a political perspective.

So if the Fed continues to ignore the signals that it has eased enough (e.g., a very weak dollar, strong commodity and gold prices, rising forward inflation expectations and a very steep yield curve) does that mean the result will be hyperinflation? I'm not prepared to say that yet, but I do think that it implies one should have at least one oar in the water pulling in the direction of assets that will benefit from a rising price level. Treasuries are most definitely not one of those assets, but equities, corporate bonds, and inflation-adjusted bonds are.

While it's scary to see gold and commodity prices shooting higher, it's not necessarily the end of the world. In real terms, gold and commodity prices are still well below their historical highs. The dollar is very weak, but it's been this weak several times in the past without resulting in a catastrophe. It's also the case that while monetary policy can have an almost immediate and profound impact on commodity prices, it can take a long time for monetary mistakes to filter through the massive U.S. economy. For example, the Fed's aggressive tightening in the late 1990s didn't cause a recession until 2001—and a mild one at that—and we didn't see a meaningful decline in the inflation statistics until mid-2003. If took four years of super-easy monetary policy, beginning in 2002, to result in an unsustainable housing price bubble in 2006. Sometimes problems can persist for much longer than one might expect.

Meanwhile, I think the dominant themes of the past year or two will continue to play out. Deflation fears are vanishing, and confidence is slowly returning. The economy is improving, and growth can trump a lot of problems. Fiscal policy is in the process of improving meaningfully. Contrary to what you see in the press, even sharp cutbacks in federal, state, and local spending needn't be bad news for the economy; reduced spending by the public sector frees up resources for the far more efficient private sector. Starve the public sector beast and you feed the private sector job-creating machine. So I remain optimistic, especially since so many people are still so worried.

UPDATE: Ronald McKinnon (a great economist whose books I studied in 1979-80) has an excellent article in the WSJ which expands on the ideas discussed in this post.