Tuesday, February 23, 2010

Gold and commodities

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.


Benjamin Cole said...

Over on Carpe Diem, Dr. Perry's economics blog, he had a recent post from Cleveland Fed putting inflation as near zero for last year.

Gold is a cult. People who talk about gold a lot usually have survivalist gear in their basements and buy chastity belts for their wives. It is medievel investing, updated through ETFs for investors from China and India.

Forget gold and any signals it may send. If you are picking up signals from gold, you need a tin foil hat.

There is speculation in metals and oil, maybe even manipulation. Remember,the CFTC is toothless, it is legal to cloak identity when trading in commodities, and even legal to plant stories about shortages etc after you have taken a big position. As much as 11 percent or more of trading a day on the NYMEX can be done by a single entity.

Oil and gold, and penny stocks. They all send signals.

The reality: Inflation is dead for years to come.

In short, we have entered a strange period in which commodity price behavior tells us nothing. The financialization and speculationification (a new word, like it?) of commodities markets.

Scott Grannis said...

Benjamin: I've been a student of gold for the past 30 years. I am not a cult follower of gold, but I deeply respect it as the most monetary of all commodities, and as something that has uniquely retained its purchasing power over hundreds and thousands of years. Of course it is subject to speculation, but when you find strong and consistent speculation over the years in one direction, it's hard to ignore the fact that this could be an important signal that monetary policy is not keeping inflation expectations and the dollar stable.

I chose the CRB spot commodity index precisely because it is minimally subject to speculative pressures; most of its components do not have futures contracts associated with them. The stuff in this index is the sort of stuff that is used everyday in the manufacture of things used by everyone in the world.

To think that speculation, hoarding and stockpiling could explain the entire move up in these commodities is difficult for me to accept.

I would also note that these commodities are at the very bottom of the economic food chain, and as such are the most sensitive to monetary policy disturbances and changes in underlying demand and supply fundamentals. The CPI represents the top of the economic food chain, and is very slow to reflect changing fundamentals. Indeed, I have always believed that the CPI is the last place you will see inflation show up. And by the time higher inflation shows up in the CPI, it's too late to do anything about it.

Scott Grannis said...

One further point, for those who think I'm stuck in a rut on my views. I am on record as forecasting declining inflation from 1998 through 2002; inflation fell from 3% in 1997 to a low of 1% in 2002. I am also on record as forecasting rising inflation beginning in late 2003. I held that view consistently as inflation rose from 1% in late 2002 to over 5% in 2008. Both of those forecasts were driven by my reading of the signals from interest rates, the dollar, gold, and commodity prices.

Benjamin Cole said...

I did not mean to suggest that you personally were cultish in matters gold; only that much of the market is. (Your commentary strikes me as very well-grounded, even if I sometimes disagree. I was not recommending a tin foil hat to you, except perhaps in a jocular way).
I do think commodity markets have changed into speculative arenas, although you make a good point about commodities for which there is no futures market.
But remember, many commodities had depressed prices--we are in a zone now where prices are recovering, giving perhaps a false inflation signal. Such commodities may start to plateau.

To repeat myself, at least in the Los Angeles market, I see little inflation. Industrial and office rents very soft, housing soft, wages soft.

It is cheaper to start a business today than three years ago.

Worse, the mood of people is still defensive, bearish. My guess is that it is not much different nationwide.

Long-term I suspect commodities prices keep falling, due to improvements in productivity and transportation.

I predict gold will be cheaper in 10 years than it is now. Electronic goods will be cheaper, clothes will be cheaper, anything manufactured will be cheaper.

Only things tied to government--health care, military--will be more costly.

A glut of capital will sometimes push real interest rates to below zero. Every scare and flight to safety will do that.

septizoniom said...

you know nothing but what the fed has manipulated over the past 35 years.

Seth said...

"It would be far better to have had a stable monetary policy and stable (and low) inflation expectations over the past few decades."

By what measure have we had high (not low) inflation expectations over the past few decades?

Scott Grannis said...

STS: There's no direct measure of inflation expectations I can point to, but I would cite the persistently high real rate on T-bonds over much of the 1980-2000 period as reflecting market expectations of inflation that were consistently higher than actual inflation proved to be.

Jeff V said...

OK Scott. Been reading you for about a year and I trust you. But looking at confidence data, housing data, announced corporate layoffs (>50), commercial real estate market, the dollar (back to safety), even the market lately, and I'm begining to wonder if we are atarting to see the beginings of a double dip.

Talk me out of it.

Unknown said...


I enjoyed this post and used the chart from it as well as some of your thoughts (with attribution and a link to your blog) in a post on my blog, which is on MarketWatch.com.


Could not find an email address for you so I'm leaving this comment. Thanks.

Kurt Brouwer

Unknown said...

I think the path for gold will continue to be driven by the policy response by the Fed and other central banks to the risks of inflation versus deflation. In my view Bernanke would strongly prefer inflation and will continue to do everything in his power to try to prevent deflation from occurring. As a result, I remain quite bullish on gold over the next several years. I think this is a beneficial piece to read on gold, deflation, and inflation, and it includes some interesting commentary from people like David Rosenberg and Gary Shilling in it:

Gold Price and Deflation - New Highs in 2010

Scott Grannis said...

Kurt: thanks

Scott Grannis said...

Jeff: I continue to believe we are in the midst of a run of the mill correction. Recessions, even double-dip recessions (which I would equate to something like a quarter or two of negative growth) don't happen easily. They require major policy errors, usually in the form of very tight monetary policy which produces high real yields and an inverted yield curve. What we see today from the Fed is exactly the opposite. Fiscal policy could deliver a double dip, but only if taxes jumped, trade wars ignited, and/or regulatory burdens increased significantly. We've had warnings on all these fronts, but the pushback Obama has received has clearly (in my mind) reduced the probability of these threats becoming reality.

Meanwhile don't forget all the improvements on the margin: swap spreads have collapsed, credit spreads are much tighter, implied vol is way down, claims are way down, the ISM indices are way up, industrial production is rebounding strongly, commodity prices have rebounded very strongly, global trade has rebounded, etc.

Scott Grannis said...

david: I've been reluctant to call strongly for gold to head higher. I think it has already priced in the expectation of a very easy Fed. If the Fed doesn't continue to stay easy even in the face of mounting evidence that it should tighten, then gold is very vulnerable.

Rosenberg and Shilling both say that it will take deflation to push gold higher, but that only makes sense if they are really arguing that gold will go higher only if the Fed continues to see deflation risk out there. To me, the gold price already signals that deflation is out of the picture entirely.

Bill said...


Isn't today's report on new home sales disturbing? It seems like the housing market is retreating from some of the improvements last year and won't it only get worse when the tax credits expire?

ronrasch said...

Scott, I enjoy and respect your use of data and look at contradicting pieces of evidence to refute. I see state pension plans underfunded and municipalities engaging in layoffs. The fed is spending money to keep people in homes that they can not afford which is a break on rising housing prices -more foreclosures coming. Unemployment continues to be high. The feds response to the air coming out of the bubble has been to print more dollars. When the bond market demands higher rates and the cost of the debt becomes staggering, will this not result in a deflationary crash? Don Hoppe,a favorite financial historian was a good forecaster of the price of gold and also predicted a deflationary depression. Thanks to all who made this a great thread and for your responses Scott.

ronrasch said...

Scott, I think your data supports the case for 3 to 4 percent growth and your predictions have shown you are using data well. I had to look at some of the factors that have so many people believing we are heading for a double dip recession or even an depression.

Scott Grannis said...

Bill: My position on housing is this: On the one hand we have almost a year's worth of data suggesting we've seen the bottom in prices. We also have about a year's worth of data suggesting that residential construction is either at the bottom or very close; it's such a small part of GDP (2.5%) at this point that whether it drops another 10% is hardly important. New home sales are at record lows because construction is at record lows. Some downdrafts in the monthly data here and there aren't really important in the great scheme of things.

On the other hand, what if housing prices fall another 10%? I would first argue that the market is already priced to a 10-25% decline, so from the market's perspective if this happens it won't be a big deal. The losses have already been reflected in the prices of the securities. And even if the price of homes goes down, the homes remain. Other people will eventually buy the cheaper homes, and they will be very happy. What's important on the margin is the number of people working and earning. All the factories, cars, homes, machinery and computers will be with us no matter what happens to housing prices. Housing prices don't drive growth, they reflect people's desire to own them relative to other things.

I see the tax credits as a bit player in this drama.

Scott Grannis said...

ronrasch: I have to believe that state spending will be the next shoe to drop. Budgets will be slashed and union and pension benefits will be under the microscope. Public sector workers have lived in nirvana conditions for years, relative to private sector workers, but that is going to have to change going forward. This is good.

As for the Fed: It's not really the case that they have printed up a ton of money that is going to cause inflation. The main thing they have done is to increase the supply of money in order to match the increase in the demand for money. By definition, this is not inflationary. It will be inflationary, of course, if the Fed's exit strategy comes to late or withdraws too little. There are lots of signs that that will be the case, but it hasn't really happened yet. The important thing is that there is not a shortage of money, so there is no reason to expect a general price deflation. Housing prices have to adjust for lower demand, but prices needn't be in freefall forever. They just have to go down by enough to restore the balance between supply (which is being reduced daily) and demand (which is largely determined by incomes, which are rising, and interest rates, which are at historical lows). We could be at that point already, or very close.

As for higher interest rates, those will only happen if the economy proves stronger than expected. And that means that higher interest rates won't be a problem, they will be part of the solution.

dave said...

I'm with you, I don't see deflation with a $1,100 gold price. I see a contraction and like you my concern is inflation .

The Keynesian's only see inflation and deflation, they need to be able to incorporate contraction and expansion into their models.

If there truly is a market clearing price , that must mean that prices can rise and fall based on supply and demand seperately from the adjustment that is brought about by changes in the value of the currency.

That the economy is as weak as it is and commodities are rising is not a sign of deflation to come but a warning that inflation is the real cause for concern.

Keep up the great work.

Public Library said...

New home construction/sales have been good leading indicators over time. With this sector in the doldrums, it is difficult to see where the economic push is going to come from in the medium to longer term. Especially with businesses focused on maximizing current staff rather than on-boarding new hires.

Additionally, we are not in an environment where companies/people are 100% focused on profit maximization. To the contrary, the overall mindset is survival and balance sheet repair. This can and most likely will take years to work its way through.

Survivalist behavior distorts economic modeling because we toss the foundation of the models out the window. This is similar to when all correlations head to 1 or -1 in a panic. It does not make macroeconomic sense but it certainly does at the micro level.

America is in for a very long and arduous Japan like slog and is unprepared for the consequences it will have on the fabric of our society. We will adapt but the days of yore are well and gone.

krispyhoochie said...

Hi Scott,

I was wondering what your opinion was of the financial sector. It seems to me that lately all the hedge funds are initiating new positions or increasing existing positions in Banks such as Wells Fargo Citigroup etc.

If Financials recover isn't this a good indication that the economy is in a better state. But, some of the same hedge funds who are long financials are also very long on gold.

Please make sense of this for me



Scott Grannis said...

krispy: The best argument I've heard in favor of the banking sector came from a good friend who sits on the board of a bank. Banks still own a lot of collateralized mortgage-backed securities, and they were forced to write down the value of those securities severely in the wake of the financial crisis in late 2008. They were forced to consider the securities "impaired" and to mark them to market, absorbing the loss on their bottom line. Since then, the prices of these securities have rebounded significantly, since the actual losses have proved to be much less than the losses implied by the distressed pricing that the banks were forced to mark to. I suspect that a lot of banks and even corporations who hold these securities in their investment accounts will eventually be writing up their value, and that will be a significant boost to their bottom line.

Also, it's reasonable to think that if the economy survives, then banks should do very well considering how battered they have been this past year or two.

krispyhoochie said...

brilliant, it's amazing how you can explain things so easily.

When you decide to write a book i will be first in line to buy it.


Seth said...


Financials are also benefiting from the near-zero interest rates from the Fed. This gives them cheap carry on almost anything they want to buy as a speculation, including (very ironically) gold.

The hedgies are playing the popularity of gold -- it's a psychological bet on crowd momentum more than a macro call.