Those rising commodity prices! It is not the Feds fault nor is it the fault of Quantitative easing. Ben Bernanke faced head on the criticism that Fed policy was a major factor in soaring answering point by point the arguments I have brought up since the beginning of QE 1 and a meeting that I had with Fed officials a few weeks ago with other commodity traders. The Fed really wanted to get our take on what was driving commodities and what impact we thought Fed Policy was having on commodity prices. Yesterday Mr. Bernanke spoke and hit all of the points that I have brought up in my daily energy report's as well as other points that were discussed in our meeting with the Fed officials.
As long time readers of my reports know since day one I have said that Quantitative Easing was wildly bullish for commodities. I said that the Fed could change the fundamentals of commodity in an instant and put bearish traders on notice that it was a dangerous proposition to be short. This was in part because of the value of the dollar but because the printing of money was even more stimulative to the price of a commodity then an interest rate cut. I wrote that Mr. Bernanke was exporting inflation to the emerging markets. Let's look at Mr. Bernanke response in full and I will add some comments along the way.
He said "As I noted earlier, the rise in commodity prices has directly increased the rate of inflation while also adversely affecting consumer confidence and consumer spending. Let's look at these price increases in closer detail.
The basic facts are familiar. Oil prices (NMN:CL1N) have risen significantly, with the spot price of West Texas Intermediate crude oil near $100 per barrel as of the end of last week, up nearly 40% from a year ago. Proportionally, prices of corn and wheat have risen even more, roughly doubling over the past year. And prices of industrial metals have increased notably as well, with aluminum and copper prices up about one-third over the past 12 months.
When the price of any product moves sharply, the economist's first instinct is to look for changes in the supply of or demand for that product. And indeed, the recent increase in commodity prices appears largely to be the result of the same factors that drove commodity prices higher throughout much of the past decade: strong gains in global demand that have not been met with commensurate increases in supply. (Agreed but the pace was quickened by Fed policy. The Movements in commodities have been much stronger then the period from 2002 to 2008 so it is obvious that there are other factors at play.)
From 2002 to 2008, a period of sustained increases in commodity prices, world economic activity registered its fastest pace of expansion in decades, rising at an average rate of about 4.5% per year. This impressive performance was led by the emerging and developing economies, where real activity expanded at a remarkable 7% per annum. The emerging market economies have likewise led the way in the recovery from the global financial crisis: From 2008 to 2010, real gross domestic product ( GDP ) rose cumulatively by about 10% in the emerging market economies even as GDP was essentially unchanged, on net, in the advanced economies.
Naturally, increased economic activity in emerging market economies has increased global demand for raw materials. Moreover, the heavy emphasis on industrial development in many emerging market economies has led their growth to be particularly intensive in the use of commodities, even as the consumption of commodities in advanced economies has stabilized or declined. For example, world oil consumption rose by 14% from 2000 to 2010; underlying this overall trend, however, was a 40% increase in oil use in emerging market economies and an outright decline of 4.5% in the advanced economies. In particular, U.S. oil consumption was about 2.5% lower in 2010 than in 2000, with net imports of oil down nearly 10%, even though U.S. real GDP rose by nearly 20% over that period. (Oh so you say it is not speculation driving price but fundamentals. Could you please tell that to the President next time you see him. And tell that to all the other misguided critics of speculation across the globe. Could you warn them of the dangers of futures over regulation and price caps that could lead to shortages and bring real damage to the economy?)
This dramatic shift in the sources of demand for commodities is not unique to oil. If anything, the pattern is even more striking for industrial metals, where double-digit percentage rates of decline in consumption by the advanced economies over the past decade have been overwhelmed by triple-digit percentage increases in consumption by the emerging market economies. (And gold, don't forget the world's favorite inflation hedge and non industrialized metal. The commodity that has soared under the umbrella of Quantitative Easing and the commodity that has benefited not only from the dollar but a lack of confidence in a paper currency. Not to mention the lack of confidence in the global banking system and economic system.)
Likewise, improving diets in the emerging market economies have significantly increased their demand for agricultural commodities. Importantly, in noting these facts, I intend no criticism of emerging markets; growth in those economies has conferred substantial economic benefits both within those countries and globally, and in any case, the consumption of raw materials relative to population in emerging-market countries remains substantially lower than in the United States and other advanced economies. Nevertheless, it is undeniable that the tremendous growth in emerging market economies has considerably increased global demand for commodities in recent years. (That is a given.)
Against this backdrop of extremely robust growth in demand, the supply of many commodities has lagged behind. For example, world oil production has increased less than 1% per year since 2004, compared with nearly 2% per year in the prior decade. In part, the slower increase in the supply of oil reflected disappointing rates of production in countries that are not part of the Organization of the Petroleum Exporting Countries (OPEC). However, OPEC has not shown much willingness to ramp up production, either. Most recently, OPEC production fell 1.3 million barrels per day from January to April of this year, reflecting the disruption to Libyan supplies and the lack of any significant offset from other OPEC producers. Indeed, OPEC's production of oil today remains about 3 million barrels per day below the peak level of mid-2008. With the demand for oil rising rapidly and the supply of crude stagnant, increases in oil prices are hardly a puzzle.
Production shortfalls have plagued many other commodities as well. Agricultural output has been hard hit by a spate of bad weather around the globe. For example, last summer's drought in Russia severely reduced that country's wheat crop. In the United States, high temperatures significantly impaired the U.S. corn crop last fall, and dry conditions are currently hurting the wheat crop in Kansas. Over the past year, droughts have also afflicted Argentina, China, and France. Fortunately, the lag between planting and harvesting for many crops is relatively short; thus, if more-typical weather patterns resume, supplies of agricultural commodities should rebound, thereby reducing the pressure on prices.
Not all commodity prices have increased, illustrating the point that supply and demand conditions can vary across markets. For example, prices for both lumber and natural gas are currently near their levels of the early 2000s. The demand for lumber has been curtailed by weakness in the U.S. construction sector, while the supply of natural gas in the United States has been increased by significant innovations in extraction techniques. Among agricultural commodities, rice prices have remained relatively subdued, reflecting favorable growing conditions. (Well because natural gas is basically a domestic commodity it has been a shielded from the global exchange rate pressures as well.)
In all, these cases reinforce the view that the fundamentals of global supply and demand have been playing a central role in recent swings in commodity prices. That said, there is usually significant uncertainty about current and prospective supply and demand. Accordingly, commodity prices, like the prices of financial assets, can be volatile as market participants react to incoming news. Recently, commodity prices seem to have been particularly responsive to news bearing on the prospects for global economic growth as well as geopolitical developments.
As the rapid growth of emerging market economies seems likely to continue, should we therefore expect continued rapid increases in the prices of globally-traded commodities? While it is certainly possible that we will see further increases, there are good reasons to believe that commodity prices will not continue to rise at the rapid rates we have seen recently. In the short run, unexpected shortfalls in the supplies of key commodities result in sharp price increases, as usage patterns and available supplies are difficult to change quickly. Over longer periods, however, high levels of commodity prices curtail demand as households and firms adjust their spending and production patterns. Indeed, as I noted earlier, we have already seen significant reductions in commodity use in the advanced economies. Likewise, over time, high prices should elicit meaningful increases in supply, both as temporary factors, such as adverse weather, abate and as investments in productive capacity come to fruition. Finally, because expectations of higher prices lead financial market participants to bid up the spot prices of commodities, predictable future developments bearing on the demands for and supplies of commodities tend already to be reflected in current prices. For these reasons, although unexpected developments could certainly lead to continued volatility in global commodity prices, it is reasonable to expect the effects of commodity prices on overall inflation to be relatively moderate in the medium term.
While supply and demand fundamentals surely account for most of the recent movements in commodity prices, some observers have attributed a significant portion of the run-up in prices to Federal Reserve policies, over and above the effects of those policies on U.S. economic growth. For example, some have argued that accommodative U.S. monetary policy has driven down the foreign exchange value of the dollar, thereby boosting the dollar price of commodities. Indeed, since February 2009, the trade-weighted dollar has fallen by about 15%. However, since February 2009, oil prices have risen 160% and nonfuel commodity prices are up by about 80%, implying that the dollar's (NYE:DXY) decline can explain, at most, only a small part of the rise in oil and other commodity prices; indeed, commodity prices have risen dramatically when measured in terms of any of the world's major currencies, not just the dollar. But even this calculation overstates the role of monetary policy, as many factors other than monetary policy affect the value of the dollar. For example, the decline in the dollar since February 2009 that I just noted followed a comparable increase in the dollar, which largely reflected flight-to-safety flows triggered by the financial crisis in the latter half of 2008; the dollar's decline since then in substantial part reflects the reversal of those flows as the crisis eased. Slow growth in the United States and a persistent trade deficit are additional, more fundamental sources of recent declines in the dollar's value; in particular, as the United States is a major oil importer, any geopolitical or other shock that increases the global price of oil will worsen our trade balance and economic outlook, which tends to depress the dollar. In this case, the direction of causality runs from commodity prices to the dollar rather than the other way around. The best way for the Federal Reserve to support the fundamental value of the dollar in the medium term is to pursue our dual mandate of maximum employment and price stability, and we will certainly do that.
Another argument that has been made is that low interest rates have pushed up commodity prices by reducing the cost of holding inventories, thus boosting commodity demand, or by encouraging speculators to push commodity futures prices above their fundamental levels. In either case, if such forces were driving commodity prices materially and persistently higher, we should see corresponding increases in commodity inventories, as higher prices curtailed consumption and boosted production relative to their fundamental levels. In fact, inventories of most commodities have not shown sizable increases over the past year as prices rose; indeed, increases in prices have often been associated with lower rather than higher levels of inventories, likely reflecting strong demand or weak supply that tends to put pressure on available stocks.
Finally, some have suggested that very low interest rates in the United States and other advanced economies have created risks of economic overheating in emerging market economies and have thus indirectly put upward pressures on commodity prices. In fact, most of the recent rapid economic growth in emerging market economies appears to reflect a bounce back from the previous recession and continuing increases in productive capacity, as their technologies and capital stocks catch up with those in advanced economies, rather than being primarily the result of monetary conditions in those countries. More fundamentally, however, whatever the source of the recent growth in the emerging markets, the authorities in those economies clearly have a range of fiscal, monetary, exchange rate, and other tools that can be used to address any overheating that may occur. As in all countries, the primary objective of monetary policy in the United States should be to promote economic growth and price stability at home, which in turn supports a stable global economic and financial environment.
Still to say the QE 1 and 2 had little impact on commodity prices is just not right. You see the historic rises we have seen in commodities since QE 1 and QE 2 goes beyond just simple math. I was pleased to see that Mr. Bernanke acknowledged that the moves in commodities were out of whack as traders sought safe haven against the unfolding credit crisis, a point that I made at the time, something that traders thought at the time was born of the same things that Ben Bernanke is talking about today. While he made a robust argument the QE the truth is that if you look at market reactions and market sentiment you also have to look at the rate expectations differentials with Europe. As evidence we have seen some of the biggest one day moves in oil after Jean Claude Trichet either joined Fed policy or fount it. Back in 2008 when Jean Claude said the Dollar was a US problem and inflation was his problem signaling rate increase oil went limit up or hit the upward circuit breaker. We saw oil go the opposite way when the ECB signaled that they would go on hold as opposed to raising rates a few weeks ago. Plus if you look at the charts we know we had an impact on prices if only because the market anticipated more demand which I guess is the point of QE in the first place. If central bank policy did not matter why the aggressive moves in markets when rate expectations change?
Add to that the Chinese currency manipulation which helps create imbalances and were magnified by quantitative easing. Bernanank answer to China was more QE exporting inflation to them forcing them to raise rates.
You see QE changed rules of the commodity game. In a blink of an eye the Fed with its unlimited power to print money can change the dollar value of a commodity or its long term trend in an instant. If only because being short is a more dangerous proposition? The fear that the Fed at anytime can run the printing press and change the fate of a commodity because the Fed has the ammunition to make it so does play into the price expectations of a commodity. The Feds policy of quantitative easing is more simulative to the economy as a good old fashion interest rate cut but at the same time it has the potential to be much more inflationary. And the Fed now that the FED has opened that Pandora Box the markets are now from this point forward have a more complex element to them. The QE2 sent investment money to the ETF's and other commodity funds reflecting tightening demand expectations but the fact that the Fed may print money again. The debasement of paper currencies across the globe makes commodities more desirable.
I think OPEC will raise its quota, yet do quota's really matter? Really we are not talking about any new oil at this point but a legitimizing of current overproduction. Of course when you raise the speed limit from 55 to 65 most people will drive 75 instead of 65. The debate is just to make some members feel like they matter. They don't. The Saudis are going to do what they want to do and at the end of the day that is all that matters. It is nice to have spare capacity.
The pipeline outage caused a big drop in crude supply on last night's American Petroleum Institute supply report causing crude to drop by 5.5 million barrels!
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