Thursday, April 15, 2010

The reflationary message of key commodity prices

Here's an interesting chart that puts key commodity prices—gold, crude oil, and industrial commodities—in perspective. I've recalibrated each so that they are equal to 100 as of Jan. 31, 1997. I chose early 1997 as a starting point, because I think that monetary, economic and inflation fundamentals were relatively stable around then. The CPI had been fairly steady at just under 3% for six years. Gold prices had been fairly steady at just under $400 for about 4 years. Industrial metals prices had been fairly steady for 2-3 years. The economy had been growing about 3% a year for 4 years. The dollar had been in a flat trend for 6-7 years.

From 1997 through 2003, we began to see the effects of monetary deflation, as the Fed tightened policy aggressively in an attempt to slow what was perceived to be an "overheating" economy. Commodities fell across the board during that period. From 2003 on, we saw the effects of monetary reflation, as the Fed responded to the deflation it had previously generated by keeping interest rates low for an "extended period." Commodity prices rose across the board during that period, not surprisingly. Then came the panic collapse of 2008, when the prices of almost everything declined as global demand evaporated But since then monetary policy has reverted to being very accommodative, demand and confidence have come back, and commodity prices are once again on the rise.

One thing about this chart really stands out: these key commodity prices have essentially tripled in the past 13 years. That works out to almost 9% inflation per year on average. Another interesting observation: gold prices and crude oil prices have risen by almost the same exact amount over this period. In addition, the ratio of gold and crude oil prices today (13 barrels per ounce of gold) is not too far off its average (17.8) for the past 50 years.

Message: these prices tend to move together over time, even though they are very distinct commodities. Gold has an intrinsic value derived from its beauty and durability; crude oil's value is purely as a source of energy; industrial metals are key inputs to most industrial processes and by extension, to economic growth in general. That they are all on the rise is a strong indication that monetary policy is increasing inflation pressures throughout the economy.


krispyhoochie said...

Hi Scott,

can you comment on Natural Gas. it has not been enjoying the same success as other commodities and, I was wondering if you could explain why.


Benjamin Cole said...

Jeez, I think this is a terrible analysis.

Demand for China and India has been pushing up commodity prices. Their monetary policies and growth economies probably have much bigger impact on commodity prices than anything the USA does. It will take commodity producers time to catch up.

China is the biggest importer of many commodities, and certainly the fastest growing. They use more steel and oil than we do, and buy more diamonds. China is the new powerhouse when it comes to materials. Lumber too. Why attribute to the sluggish USA economy anything in commodities markets, when demand from China is booming?
Look to Beijing.

In addition, you have a cartel--OPEC--manipulating oil prices, obviously and publicly through production, and possibly through speculation and manipulation on the NYMEX. With such a powerful cartel, and with production sagging in so many thug-state countries such as Venezuela, Mexico and Iran, oil could go up even if the globe or USA was following a tight money policy. An artificial global scarcity of crude oil is not a sign of any an expansive Fed policy.

Natural gas prices are soft due to huge increases in supply--again, reflecting incredibly smart technology (shale gas), not a restrictive monetary policy.

Gold is gold, a metal of that fevers the mind. Both Indians and Chines revere gold as an investment--and they have more disposable income. Again, means little or nothing that gold is going up. Gold is lower than in the mid-late 1980s. Gold is gold.

But really, if money supply influences commodity prices, then it must be the global money supply we look at now, not just the Fed. China is expanding its money supply at a 22 percent annual rate--that probably has a much bigger impact on commodity prices than the flat growth on M2 of late.

The topper is that Ben Bernanke says he sees decelerating inflation.

I think this connection between global commodities markets and the US money supply is getting increasingly murky, to the point of mud.

Gary said...


Bernanke also assured us in 2007 that the subprime contagion was "well contained".

Fool you once, shame on Bernanke. Fool you again, shame on you.


So if inflation over the last 13 years has been ~9% -- which by the way ties out with many consumer's actual cost of living and CPI does *NOT* -- are you saying that US Treasury "investors" were (and are) marks?

Scott Grannis said...

I'm not saying that inflation was 9%. These commodities could be leading indicators of the inflation yet to come. As for the bond market, I have said several times before that I don't believe the bond market is very good at anticipating inflation. The bond market currently says that inflation is not a problem, but the bond market could be terribly wrong. The bond market was behind the inflation curve all the way through the 1970s, and then it overestimated inflation all the way through the 80s and 90s.

Gary said...

Scott, I would have to do a lot of digging to find this chart (and I don't think your blog lets commenter's post a jpg)...

Anyway, the chart shows the 1yr change in WTI crude prices (nearby contract) with the 1yr change in total CPI (lagged by 1 month -- oil predicts CPI)

The correlation of the percent changes (not the prices) is north of 0.8 (varies over time, but eyeballing it 85-90% looks like the average)

However, the magnitude of the oil price changes is (eyeballing again, as the chart author doesn't say) about 10x the magnitude of the CPI changes

Energy costs are a lot more than 10% of the economy -- last figure I heard was 22%

Gary said...
This comment has been removed by the author.
Scott Grannis said...

Actually, energy is a bit less than 10% of the economy. A 10% rise in oil prices would therefore tend to result in a 1 percentage point increase in the CPI, all other things being equal (which is not always the case of course).

Gary said...

Scott -- 10% versus 20% depends a lot on whether you consider government spending to be part of the economy. Some people would argue that this "spending" is just administrative overhead (not economic activity at all), and at any rate it is paid for with debt that (in theory) has to be paid back.

If I go borrow $2 trillion from Wachovia or Lehman (they did make loans that made even less sense)... that doesn't make me a $2 trillion economy.

Anyway, if you are agreeing (materially) with that chart, then you are saying that CPI and commodities (which you stated in the post are all correlated) should be correlated in percentage terms... so that would suggest that CPI should be ~9% ???

We can argue about energy -- but in aggregate, commodities are going to be the raw material for the whole economy. Sorry, hot air from lawyers and investment bankers is just pocket pool -- they don't create any value in aggregate

Gary said...

Scott -- just checked the dept of energy website...

Energy was 8.4% of GDP in 2005 (the latest year figures are available). That is total GDP (not just the private sector) and more importantly, it is not adjusted for the massive increase in debt. Debt based growth is not the same as real growth.

WTI crude oil averaged around $55/bbl in 2005, versus about $80 for this year -- a 45% increase.. GDP has increased about 15% over the same period.

That makes energy about 11% of total GDP -- including government and not adjusting for debt / leverage

Bill said...

This also helps to explain the real estate "bubble" of the 2000s. Prices were clearly moving upwards in concert with commodities and inflation generally. Note that commodities also had a tremendous correction but are now nearly recovered. Are real estate prices soon to recover also?

John said...

I am not a Raymond James customer (my old firm was swallowed by Wachovia, and they were swallowed by Wells Fargo) but I have long been an admirer of Jeffrey Saut, their chief market strategist. To RJ's credit, they provide periodic FREE missives on the market from Mr. Saut to the public on their website. This week's comment involves a discussion on potential inflation. Since this post by Scott is on the same subject I thought I would provide those interested the RJ web address. It is relevant to this discussion and I recommend it for the sake of additional perspective.

dave said...

Global Commodities are priced in dollars so the value of the dollar has every thing to do with movement
in commodity prices.

Scott has correctly in my opinion pointed out a tripling in commodity prices since the late nineties before the Maestro decided he would rid us of our irrational exuberance with a dose of deflationary monetary policy.

You seem to totally miss the influence on prices that monetary policy , both good and bad exert.

If prices were only driven by supply and demand the slow down in global activity should have brought prices back to the level they were in 1997. It didn't and the reason it didn't is because the entire price level has increased due to the Feds policy of easy money.

Benjamin Cole said...

Dave, Scott and others:

China announced their first-quarter GDP is up by 11.2 percent! They say they expanded their money supply by 22 percent in the last year. and have engaged in a huge stimulus program.

They import more iron-steel, lumber, diamonds and oil than we do. To say there are the world's manufacturing platform is obvious. It just makes sense that what China does impacts commodities prices more than the USA. In energy blogs, there is constant chatter about Chinese demand and what it means to future crude prices--for good reason. They are the one growing rapidly at the margin, while US demand is stagnant. Europe's demand has been falling for decades.

Commodities may be priced in dollars when the Chinese buy them, but they fix the yuan to the dollar. It is pegged! Remember--no free market in yuan-dollar exchange rate. Think about it.

The Chinese decide pay in yuan, get it converted to dollars, and buy. And since they have a lot of yuan, it creates demand--and pulls up the dollar price.

As to 1997 commodities prices, the world economy has grown a lot since then, again thanks to Asia, India and China. Real physical demand for commodities is strong. This is a good thing.

You have the complicating factor of OPEC, and the fact that so many oil-producing nations are thug-states. Think about just four: Venezuela, Mexico, Iraq and Iran. (Yes, I hope Iraq is or becomes a better place). Each country has shot itself in the foot crude production-wise, due mostly to incredibly corrupt regimes. Chavez is not a figment of monetary policy, he is a tin-pit tyrant.

So, oil production goes down, and prices goes up. This has little to do with monetary policy.

To look at global commodities prices and tie to to Fed actions is a stretch. Add to it that M2 supply is up 2 percent in the last year--aganst a 22 percent hike in yuan supply, even though the yuan is pegged to the dollar.

Jeez, guys, this one is not hard to figure out. China is driving global commodities prices, not the USA.

John said...


Below is a NYT link discussing China's attempts to control the internet. It strikes me this is a country still afraid of its people. Its one of many reasons why I prefer no direct investments there and why truly big money will not seek long term shelter there. Stratfor could still be right about the country fracturing.

Benjamin Cole said...


The link did not work, but in general I agree it is crazy for China to be repressive, and it should move to a democratic, free-enterprise-type state.

That said, they are doing 11 percent GDP growth, and have a strong work ethic, little alcoholism (Russia's bane) and a good culture.

The news programs I watch that originate from China (on channel 44.8 in Los Angeles) seem to be very business oriented, and there is one business news show. It seems like an entire country crazy about money. There is little or no militarism expressed on these shows.

As I said before, I do not like China stocks due to limited shareholder rights and lack of corporate transparency. Given that the SEC may prevent shareholders from putting up their own slates for American boards of public companies, I may decide not to be a shareholders in any US stocks either.

By circumstance, I am heavily invested in Thailand farmland and commodities. From that perspective, I can feel China influence, and buying power.

Basically, if you can grow it, you can sell it to China. Wood, sugar, palm oil, corn.

I suspect in 10-20 years, powerful Chinese manufacturers will source basic manufacturing in Thailand, as will Western manufacturers (China itself will become too expensive, much like Japan).

So, I see a long, long bull run for China and Thailand. My sense is that it will be a bull run on the order of generations.

Both nations would do well to increase transparency, and human rights. America's ruling class learned long ago that free press, democracy and free enterprise are terrible ways to run a country--but better than any other way.

Guava said...

Natural gas futures gained as a stronger economy and prices near $4 per million British thermal units lured buyers of the industrial and power-plant fuel.

krispyhoochie said...

Don't mean to be rude,

But does anyone want to explain to me why natural gas has been such a laggard and why the oil to natural gas relationship is so wide presently.

Why is it that natural gas is the only commodity not to run up.

If supply is your answer i'm looking for better than that


John said...


I'll take a stab at your question. There are likely other factors involved but I think one signficant reason IS supply vs demand. I know it sounds trite but sometimes the simple answer is the best one. Natty gas is difficult to transport (unlike oil) so it is highly localized. That means that surpluses in one area, the USA for example, cannot be easily and cheaply transported to other areas, Europe for example, where there are spot shortages.

There has been a fairly recent technological breakthrough recently that has served to increase the supply. It is quite significant and has increased the reserves in this country enough to affect the trading psychology. So there has been a large supply increase with no corresponding near term increase in the prospects for demand increases. Thus there is no urgency for users to 'lock up' supply sources. Confidence that supply will be available is high. Thus, prices stay depressed.

Hope this helps.

John said...


Sorry the link did not work. I have trouble with copy & paste on this blog so I tried to type it.

Not that important.

I am just a little fearful of direct China investments. I know lots of folks have done well and you have investments in the far east that should do well. I have always believed that political and economic freedom walk through time hand in hand and I just don't see any handholding there. Just me.

John said...


One more thing: You are not even remotely being rude.