Metals rally on growth outlook and not on increasing inflation expectations

In many areas like natural science, you can not be right for the wrong reason. However, financial and commodity markets are an exception. Within one week, two of the main central banks decided on important monetary policy measures. Metals markets rallied and some commentators argued rising metal prices were based on increasing inflation expectations. However, inflation is not looming, neither in the eurozone nor in the US.

The ECB’s decision to buy short-term government bonds in the secondary market if a country asks the EFSF or the ESM for help has been criticized, especially by inflation paranoid German politicians and newspaper commentators, as leading sooner or later towards rising inflation rates. Even repeating this argument in parliament does not provide any sound economic basis. The ECB stated that all purchases under the “outright monetary transaction (OTM)” program will be sterilized. Thus, OTM will not lead to an increase of the ECB balance sheet. Furthermore, the number of eurozone countries being in a recession is increasing. Also core countries like Germany are likely to slow down and get close to recession in 2013. Thus, the risk in the eurozone is more biased towards deflation than inflation. Yes, it is true that food and energy prices are increasing, but this is just a change of relative prices and not inflation.

The Fed has not disappointed the majority of Wall Street economists. A majority of 65% expected the FOMC to implement the third round of quantitative easing, called QE3. However, the FOMC surprised the bond markets by announcing to buy $40bn of mortgage backed securities (MBS) per month for an unlimited period until the target unemployment rate is reached. Treasury notes and bonds will not profit from QE3 but operation twist will be continued. Thus, the Fed will extend its balance sheet.

With QE3, one condition for increasing inflation rates according to the famous Fisher equation will be fulfilled. Thus, it is not surprising that inflation expectations, as measured by the spread of yields on conventional and inflation-linked US Treasury notes, have risen over the last few days and weeks. However, as the past 20 years have shown, increasing money supply does not necessarily lead to rising inflation. Monetarists have made some assumptions to reach their conclusion that extending money supply would lead to inflation. One assumption is the constant velocity of money. But the velocity of money in circulation has declined steadily. The more important assumption is the full employment of resources.

The decision of the FOMC to provide more liquidity by unconventional monetary policy measures is based on the violation of the assumption of full employment. The current unemployment rate of 8.1% is far above the natural level, which is estimated to be between 5 – 6%. Furthermore, the decline of the unemployment rate was to a large degree the result of unemployed persons leaving the work-force. While a certain fraction of leaving the work-force could be explained by retiring baby-boomers, the vast majority has left because they see currently no chance of finding a job. However, it is also well known that the work-force participation increases again in times of stronger economic growth.

But it is not only the work-force, which is not fully employed. Also the second production factor capital is not fully utilized. One day after the FOMC meeting, the Fed released the data for industrial production and capacity utilization in August. Industrial production declined by 1.2% compared to the previous month and capacity utilization fell from 79.2 to 78.2%, which is 2.6% below the long-term average of 80.3%. But even in the case that QE3 would lead to an increase of the capacity utilization above the long-term average, it is not immediately inflationary. Only if capacities were almost fully used, inflationary pressure would build.

The measures taken by the FOMC could lead to an improvement of US GDP growth. This is the main reason, why investors have increased their risk appetite again and buy risky assets and sell safe haven US Treasury notes and bonds. QE3 also has an impact on the US dollar as buying risky assets also includes buying assets denominated in foreign currencies. If markets were not convinced that the Fed policy would lead to stronger growth, base metals would still trade at lower levels. However, also base metals rallied and this surge in prices can not be explained only with fears of higher inflation rates by some gold bugs. It is improved global growth prospects, not inflation, which drive precious and base metals prices.