Monday, October 12, 2009

Commodities are still cheap

This is one of my long-time favorite charts. It is based on the Commodity Research Bureau's index of spot commodity prices, none of which is energy, and only a few of which have associated futures contracts. So big swings in energy prices don't distort the index much, and speculative activities that might cause price distortions are mitigated. These are just plain old commodities that are included in all kinds of basic manufacturing. As the CRB says, "the commodities used are in most cases either raw materials or products close to the initial production stage..."

I've taken the index and adjusted it for inflation using the PCE deflator, which is arguably the best measure of inflation on a monthly basis. I've chosen to start the index in 1970, mainly because commodity prices didn't do much in the 1960s, whereas a lot of exciting things happened in the 1970s.

Note that in real terms, commodity prices today are about 30% lower than they were in 1970, and about 60% lower than they were at the peak of the commodities boom in 1974. (In nominal terms, prices today are up 220% from early 1970, and up 50% from the peak in 1974.) So one message here is that commodities have not risen nearly as much as inflation. This goes straight to the assertion by the late Julian Simon that commodity prices will, over long periods, get cheaper and cheaper in real terms, thanks to human ingenuity (i.e., more efficient production methods), and despite the ever-growing global demand for commodities.

But the other, perhaps more important message, is that monetary policy has a big impact on commodity prices. The key driver of soaring commodity prices in the 1970s was the Fed's accommodative monetary policy, which actually started in the mid-1960s, and which was exacerbated by Nixon's devaluation of the dollar relative to gold in 1971. As a result of easy money, the dollar collapsed against most currencies and virtually all commodities in the 1970, and inflation reached double-digit levels by the early 1980s.

Commodity prices rose during the easy-money 1970s, but they fell by two-thirds in real terms during the period which began with Volcker's tightening in the late 1970s and ended with Greenspan's decision to slash short-term rates in 2001. Tight money is really bad for commodities, and Greenspan's extremely tight monetary policy in the late 1990s came close to producing a global deflation in the early 2000s. More recently, with monetary policy having been accommodative throughout most of the period since 2001, and especially today, commodity prices have risen about 50% in inflation-adjusted terms.

The clear implication of this chart is that commodities have considerable upside potential as long as monetary policy remains accommodative.

Why is easy money good for commodities?To put it in very general terms, it's because easy money reduces the demand for financial assets and boosts the demand for tangible assets. Low interest rates facilitate speculation in commodities, and they also facilitate purchases of land and other real assets. Building things (e.g., homes, skyscrapers, industrial plants, warehouses, dams, etc.) becomes generally more attractive when interest rates are low and money is easy, and it takes commodities to do that. China (and most lesser-developed economies which have an abundance of labor and a shortage of capital) flourishes with easy money, while Wall Street suffers.

When money is tight, this dynamic reverses. High interest rates attract money away from physical activities; it's easier to make money by buying financial assets than it is by buying tangible assets and building things. Wall Street flourishes with tight money, while China (and commodity producers) suffers.


__ said...

How are you defining 'easy' or 'tight' money?

Scott Grannis said...

Good question. There are lots of ways to define tight money, and I think all need to be present. To begin with, the Fed will tell you if they are tight or not; if they are trying to bring down inflation or not; if they are trying to fight inflationary pressures or not. Another way to tell is to look at real short-term interest rates, which are almost always above average when the Fed is tight, and below average when the Fed is easy. Tight money usually goes hand in hand with a stable or rising dollar; when money is tight it means that money being supplied is not enough to meet the demand for money, and that is a recipe for a rising currency. Tight money usually brings about declining prices for gold and commodities, while easy money makes it easy for gold and commodity prices to rise. Tight money usually produces a flat yield curve, while easy money leads to a steep curve.

__ said...

Thanks Scott. I was interested more in the quantification than the CB speak. There are other ways, e.g. by measuring policy vs. a Taylor Rule.

Scott Grannis said...

I don't think you can rely on any one method to determine if the Fed is tight or not. I look at all the indicators and then come to a conclusion. The Taylor Rule can certainly be useful, and I should have included it, but in a way it is redundant if you use the other market based indicators.