Tuesday, August 31, 2010

Gold leads commodity prices, and both respond to monetary policy

This chart covers almost 30 years of gold and commodity prices, and I think it shows an impressive correlation between the two. Moreover, it shows that gold prices tend to lead commodity prices—by as much as a year—at important turning points, which further suggests that commodities likely still have some impressive upside potential.

I think it's also important to note the strong correlation between gold and commodity prices, which speaks volumes about how important monetary policy is to both commodities. It's no coincidence that both gold and commodities trended lower throughout the 1981-2001 period, during which time the Federal Reserve was generally pursuing a policy that brought inflation down and kept it relatively low. Recall also that just the opposite happened in the 1970s, when the Fed was generally easy and inflation, gold, and commodity prices rose.

And it's no coincidence that gold turned up in early 2001, followed by commodities by the end of the year, as the Fed embarked on what would eventually prove to be the most dramatic reduction in short-term interest rates in modern times: lowering the Fed funds target rate from 6.5% to 1% over a 3 1/2 year period.

So, gold and commodity prices can be strongly influenced by monetary policy. Of course, commodity prices can also be influenced by the imbalances that arise between the growth-driven demand for commodities and their supply. But from the looks of this chart—gold and commodities were weakest in the late 1990s when the economy was so strong that the Fed worried about "overheating"—monetary policy is the more important influence.

And so the ongoing rise in gold and commodity prices is an important sign that monetary policy is easy, and thus likely to result in rising inflation.


Charles said...

Commodity prices are probably the best measure of monetary policy, especially for the preeminent global reserve currency. I am very skeptical that MV=PO works as a policy tool any longer, given globalization, financial innovation and technological changes. And it was never clear to me how the fed could find the right interest rate target that would keep the economy on a stable trajectory. As macroeconomic constructs go, commodity prices are about as concrete, measurable and timely as it gets. It is certainly superior to nominal GDP in that regard.

Commodity prices suggest that monetary policy has been about right.

But we should not delude ourselves that the key to prosperity is macroeconomic fiddling.

Public Library said...

There is no doubt what the Fed is trying to do. It truly is bending what is going on in this country.

"Consider that if our rate of inflation were high enough, used cars would rise in price just like new cars, only at a slower rate."

"As we have seen, the whole concept of rising asset prices and stock investments constantly increasing in value is an economic illusion. What we are really seeing is our currency being devalued by the addition of new currency issued by the central bank.

The prices of stocks, houses, gold, etc., do not really rise; they merely do better at keeping their value than do paper bills and digital checking accounts, since their supply is not increasing as fast as are paper bills and digital checking accounts."

"The fact that we have to save for the future is, in fact, an outrage. Were no money printed by the government and the banks, things would get cheaper through time, and we would not need much money for retirement, because it would cost much less to live each day then than it does now. But we are forced to invest in today's government-manipulated inflation-creation world in order to try to keep our purchasing power constant."


Public Library said...

And more to Scott's point. Sorry for the copy paste but completely relevant to today and this discussion.

"Newly printed money can affect asset prices more than consumer prices. Most people think that the Federal Reserve has done a good job of preventing inflation over the last twenty-plus years. The reality is that it has created a tremendous amount of money, but that the money has disproportionately flowed into financial markets instead of into the real economy, where it would have otherwise created drastically more price inflation.

There are two main reasons for this channeling of money into financial assets. The first is changes in the financial system in the mid and late 1980s, when an explosive growth of domestic credit channels outside of traditional bank lending opened up in the financial markets. The second is changes in the US trade deficit in the late 1980s, wherein it became larger, and export receipts received by foreigners were increasingly recycled by foreign central banks into US asset markets.[10] As financial economist Peter Warburton states,

a diversification of the credit process has shifted the centre of gravity away from conventional bank lending. The ascendancy of financial markets and the proliferation of domestic credit channels outside the [traditional] monetary system have greatly diminished the linkages between … credit expansion and price inflation in the large western economies. The impressive reduction of inflation is a dangerous illusion; it has been obtained largely by substituting one set of serious problems for another.

This insight into the explanation for a lack of price inflation in recent decades should also show that the massive amount of reserves the Fed created in 2008 and 2009 — in response to the recession — might not lead to quite the wild consumer-price inflation everyone expects when it eventually leaves the banking system but instead to wild asset price inflation."

randy said...

Benjamin strongly argues for QE2 hoping for a little inflation. It seems clear that the *fear* of deflation is an awful thing for the economy, so maybe a little inflation is the only way to resolve that. But it isn't clear to me how QE2 would effect that - like Public's comments - where would all the new money supply go? Banks won't lend more will they? Are businesses and consumers going to borrow and spend more ( even if offered credit ) if rates drop more? Or instead is additional money supply just going to be recycled into treasury bonds? And more often German and emerging market govt debt? If that's the case, how will more money supply help us? A question, not a position.

Benjamin Cole said...

Global gold and commodity prices go up in response to global demand.

Global demand is high now, but mostly outside of the United States. I don't understand why this is even controversial. According to the Wolrd Gold Council, the USA is but a bit player in gold markets. And investors are a bit player in gold markets, which are dominated by jewellery demand.

In particular, gold is a market dominated by India and China--you think they are there in Calcutta and Beijing, pondering what the Fed is doing, when they buy jewellery? This strains credulity.

Both China and India are posting 10percent (roughly) annual increases in GDP. Let's look at glass--China makes 45 percent of the world's glass. The USA 10 percent. Though China's GDP is smaller than ours, in real goods and contrsution, it sometimes dwarfs ours. They use far more steel, glass and raw materials than we do.

Most emerging markets are doing well, and even Europe is blundering ahead.

Suffocating under tight money some structral problems (minimum wage, rural subsidies, bloated military, home mortgage interest tax deduction, Fannie, Freddie, USDA) and dead inflation, the USA is the caboose, not the locomotive.


Yes, we need an aggressive Fed, not some Neville Chamberlain-like appeasers to hidden bond market vigilantes. The weak dithering of the Fed, the timidity is inexcusable. "We could do more but we won't." And why? With inflation at one percent and sinking?

Yesterday I posted a news release of major sale, a few thousand units, of good-quality apartments at well under $70k a pop.

How are we living in inflationary times? If anyone believes in inflation, why are good-quality apartment units selling for (roughly) half-off? That is not a sign of inflationary environemnt.

The apartments sale is a real sale in the USA now, not some tea leaves-gold prices voodoo. People who say we ahve something to fear from inflation are now grasping at straws.

Time for the Fed to get serious about its job and charter. Timidity is not leadership.

Charles said...

The divergences between gold and commodities are more interesting to me than the correlation. Gold is the alternative to government money. So the price of gold rises when confidence in central bankers falls. This may or may not correspond to rising industrial commodity prices.