Friday, January 14, 2011

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.


brodero said...

While the public sector in the states are undergoing a belt tightening that
is long overdue ( especially pensions) the ideology that the the a broad cut of public sector
expenditures is essential is short sighted. Education is extremely important
to the continued success of this
country. The firing of teachers is
probably the most naive and destructive item that is coming out
of this crisis. We as a country will pay a greater price if our education system suffers.

Public Library said...

I just can't swallow the Fed saved the day in 2008 pill. IMHO, it goes back to why the market gyrated in the first place and this inevitably leads back to the Fed and monetary policy.

So to say they did the right thing leaves out the fact that they were a hug reason for the problem in the first place.

Without an honest discussion about the latter, we will most assuredly find ourselves hailing for the Fed to save us from themselves again.

piefarmer said...

The strong correlation between commodities and monetary policy leaves less room for the argument that the commodity boom is growth driven. Baa - Aaa spreads are consistent with sub 3% growth. Stagflation, here we come.

Scott Grannis said...

brodero: There are many non-destructive ways to cut public spending. Start with pension reform. Then privatize public education (vouchers, charter schools).

Scott Grannis said...

Public: you are very right. The Fed needs to follow a rules-based policy instead of flying by the seat of the pants.

Scott Grannis said...

REW: The U.S. is not growing strongly yet, but a lot of other countries are. Commodities are a global market. You can't rule out or minimize growth as a factor.

Buddy R Pacifico said...

"The Fed should target nominal GDP..."

Scott, could please explain this some. Maybe you did but it did not sink in. Thanks.

Benjamin Cole said...

Cut public spending?

I think we can eliminate HUD, Dep't of Labor, Education, Commerce, USDA and cut defense spending by three-quarters.

Does anyone really believe life is better as a result of money spent on these agencies?

Federal agencies tend to become coprolitic over time. Private-sector companies continually do more with less. Public agencies continually do less with more. They have to be sunsetted every 10 years, including the Pentagon.

Scott has been talking about commodities for a long time. However, commodities are becoming a smaller and smaller part of the total economy, and prices are not set in America anymore.

We cannot risk tightening our money supply, and doing a Japan repeat, just because India and China and buying commodities and gold.

The Bank of Japan tried putting the monetary noose around the neck of their economy. It is an abject failure, hurtful to all involved.

Moderate inflation we can live with--the 1990s were great. Too low inflation (where we are now) or deflation will ruin us. See Japan.

Benjamin Cole said...


I find Scott Sumner to also be an engaging blogger. He favors a stimulative QE policy at this time.

Well, making predictions is hard, especially about the future, but we will see how this QE works out. I have high hopes.

Benjamin Cole said...

BTW, Krugman is running a chart, showing the US dollar collapsed in Reagan's second term (84-88). Why did the dollar collapse in Reagan's secon term?

Yet inflation continue to fall in the 1990s, and we had one of our best decades ever.

Why so?

Scott Grannis said...

Buddy: re nominal GDP targeting. I don't pretend to understand this fully, but Sumner does a pretty good job of explaining it here:

Scott Grannis said...

Re: the dollar's collapse in Reagan's second term.

Trashing the dollar was one of the biggest mistakes that the Reagan admistration made. They were persuaded that the dollar was "too strong" and they capitulated with the Plaza Accord. Volcker pitched in, and the dollar collapsed, helping to trigger the disastrous equity market collapse of Oct. 1987. Inflation subsequently rose to almost 6% by 1990.

Benjamin Cole said...

Yeah I remember that odd session in Oct. 1987 when the market fell by 20+ percent in one day.

Still, the 1990s were a terrific decade, low inflation, federal surpluses, huge rallies on Wall Street, good property markets, rising worker incomes.

I'll take the 1990s any day.

Public Library said...

Oil and its impact on economies.

With the current Fed regime at the helm, oil will keep heading north until this baby busts all over again.

Then what?

Benjamin Cole said...

BTW, over at Scott Sumner's he posted a link to a 2005 FOMC meeting in which members seemingly all agreed the CPI overstates inflation by about one percent.

If that is true, we are actually in deflation now and have been for about a year or two.

Surely, given deflation and unemployment near 10 percent, one cannot accuse the Fed of being "too stimulative."

Buddy R Pacifico said...

Scott, thanks for the article on trageting nominal GDP.

Benjamin Cole said...

"The Board’s staff estimates that the CPI overstates changes in the cost of living nearly 1 percentage point per year and that the change in PCE [personal
consumption expenditures] prices is biased upward about 1⁄2 percentage point per year. In framing your objective in terms of a published index, you will want to take this bias into account. "

From 2005 FOMC board meeting.

Sheesh, we are in deflation now, if this is correct. I am about as worried about inflation as I am about getting beaten up by Liberace.

brodero said...

I do agree vouchers keep school
systems but you have cuts coming
that preclude even that idea ( basically the voucher idea would be underfunded thereby creating
a defacto cut)...As an adjunct since there is interest in political
matters on this blog. There are
events occuring now in Texas which
will have long term ramifications for the national Republican Party.
Texas is in the clock...and if the
Hispanic community feels it is getting shortchanged in matters of
education amd immigration....look out...the 2 minute warning will be
in 2016 and the game over in 2020
if they shortchange that voting bloc ( and they are more monolithic
than you think...its just they don't vote as much)

Public Library said...


I think the majority of the US population is going to feel undercut in the next several years. Lookout below...

Benjamin Cole said...

BTW, another rally on the Dow today. Rally, rally, rally.

I think the stars are aligned for a secular bull market. Could last for years.

I have predicted 13k on the Dow for 2011, which is rapidly looking like a namby-pamby prediction.

septizoniom said...

terrific post

The Lantern said...

Interesting stuff.

As the US becomes a smaller and smaller share of global commodity demand, I would wonder how explanatory some of those variables will be in the future performance of our economy. I still think deflation is a huge risk until home prices and wages start to rise consistently. Most folks' biggest financial assets are their careers and their homes. Until we see some appreciation in those measures (wages, house prices) it will be really difficult to turn the corner and declare victory.

Paul said...


"There are
events occuring now in Texas which
will have long term ramifications for the national Republican Party."

What events? I live in Texas and am not sure what you mean. Yes, there are some education budget cuts coming to help close the budget gap. Alot of superintendents, assistants to superintendents, assistants to the assistants of superintendents, etc., are going to experience downsizing. Why should they be insulated from the real world?