Are high commodity prices really a risk for global growth?

In this week’s contribution, we will comment on an article on the rise of commodity prices and global growth, which had been published in the January 22 edition of “The Economist”. From our point of view, even the Economist lacks some basic economic understandings.

The article creates the impression that the second round of quantitative easing by the Fed was the main driver of rising commodity prices. This is not the case. First, commodities are not a homogeneous asset class, but each commodity has its own supply and demand fundamentals, even as there are some common factors. Large financial institutions, in particular the hedge funds and CTAs buy commodities not only because of the available liquidity but that fundamentals point to a trend of rising prices. If fundamentals are bearish, these institutions sell commodities despite low US interest rates and quantitative easing. This explains that some base metals posted strong gains in 2010 while zinc even declined.

Second, when talking about commodities in general, we need to look at an index, like the CRB Index. According to the CRB index, commodity prices declined during the first five months of last year and found a bottom in late May. The CRB pared the loss in June and July. However, at this time, the discussion in financial markets was whether a double dip recession of the US economy was avoidable. This recovery could not reflect a reduced concern about global economic prospects. In the eurozone, the rescue package for Greece has been approved, but markets feared still the result of stress tests for the banking system.

Third, the major push in commodity prices was triggered by rising prices of agricultural commodities. The wildfires in Russia and the drought in the Black Sea region caused a slump in grain harvests. In addition, the USDA had also revised lower the forecasts for grain harvests in the US. Floods in India and Pakistan had an impact on sugar prices. The La Nina weather phenomenon is responsible for the flood in Australia’s grain belt (Queensland) and also for the poor harvest outlook for Latin-America. Mr. Bernanke is certainly a powerful central banker, but it would be new that he is that mighty to make rain or sunshine by buying US Treasury paper.

We fully agree that Mr. Bernanke’s speech at the Jackson Hole meeting in late August marked a turning point for the US stock market. And increasing equity prices are a sign of an economic improvement, which has been reflected in higher GDP growth rates in the US. However, as already explained in earlier contributions, QE2 was not a necessary requirement for a weaker US dollar. Capital flows out of the US dollar and in to other economies where higher returns are achievable would have driven the US dollar lower even without QE2. Thus, the Fed monetary policy has supported a rise of commodity prices, but it was not the main driver.

Some economists compare rising commodity prices with a tax hike. The writer of the article in The Economist at least referred to a consumption tax. However, this comparison shows another lack of understanding basic economic principles. A hike of a direct tax, like the income tax, would leave relative prices unchanged initially. It would reduce the disposable income of private households. But if the government spends higher tax revenues and keeps the fiscal balance unchanged, then aggregate demand could even increase according to the multiplier effects. Also in the case of a general consumption tax with a single tax rate, the relative prices of goods would not be altered initially. However, due to higher prices, private consumption would be lower in real terms. But the overall impact on aggregate real demand depends again on the use of tax revenues by the government. In both cases, redistributive impacts of the fiscal policy and the preferences of the individuals affected by the tax are likely to lead to adjustments in the demand patterns, which result in changes of relative prices at the end of the process. But a specific indirect tax on a good would alter relative prices immediately. Depending on the price elasticity, the result is most likely that the demand for all goods will decline. Economists usually consider in textbooks the case of two goods. However, for aggregate nominal demand and thus for GDP growth, it is again decisive how the government spends the tax revenues. In the case of a tax rate hike, the tax policy is the cause for adjustments of the supply and demand curves for various goods. However, aggregate demand is not necessarily declining as long as the government spends the tax revenues again. By contrast, the current fiscal policy in the UK, where the hike of VAT is used to reduce the budget deficit is having a negative impact on aggregate demand.

The rise of commodity prices is not the result of tax rate hikes. Rather it reflects the adjustments to fundamental changes in the supply and demand for commodities. In the agricultural sector, the growing world population and higher incomes in many emerging markets leads to a trend of growing demand. The weather conditions around the globe have caused a drop of world supply of many agricultural commodities. As a result, prices have risen to match supply and demand. For base metals, the demand has risen due to the strong economic recovery in emerging countries in Asia and Latin-America. However, the supply situation was different. Tin production was also affected by weather conditions, which led to lower mining output in Indonesia. The copper production also could not keep pace with demand as the ore contains less copper and demand has jumped not only due to economic growth but also due to the demand for physically backed ETFs. Thus, the rise of commodity prices reflects either a stronger increase of demand or supply shocks caused by external factors. The rising demand by consumers is more a reflection of solid global economic growth and not a risk for growth going forward.

In economic theory, inflation is defined as an increase of the overall price level and a clear distinction is made to changes in relative prices. However, the way inflation is measured, a change of relative prices in one segment could lead to the perception of rising inflation. And this is the main risk for global growth as central banks have the duty to prevent inflation. Theoretically, central bankers should look through a one-off increase in commodity prices. Most likely, we could expect that the Fed would be smart enough to act accordingly. The Fed focuses on core inflation, excluding the rather volatile Food and Energy sector. China has already raised interest rate twice in the final quarter of 2010. In the eurozone, ECB president Trichet stated recently that the governing council should focus on headline inflation. The harmonized CPI surprisingly increased to 2.2% reflecting not only rising commodity prices but also tax hikes in some countries to reduce the budget deficits. The ECB expects that the inflation rate would remain above the 2% target for a few more months, but would decline again in the medium-term. Nevertheless, they left no doubt to tighten monetary policy if needed to keep expectations of headline inflation anchored at 2%. In the UK, the Monetary Policy Council of the BoE already discussed a rate hike in January as the inflation rate is above the upper target ceiling, again largely driven by increasing Food and Energy costs as well as a hike of the VAT rate from 17.5 to 20%. As long as central bankers believe that higher interest rates could have an impact on weather conditions, they pose a risk to global growth.