Commodity prices have risen dramatically over the last year, especially in basic agricultural commodities (grains, soy, cotton), certain industrial metals (copper, palladium, rare earth) and lumber. Concise evidence of this rise is seen in the CRB Index
, a price index of 19 commodities, including many of those cited; this index has risen 26.3% over the last year, and 31.2% just since late August. Not coincidentally, on August 27, 2010, Federal Reserve Chairman Ben Bernanke gave a speech
announcing that a new round of targeted monetary quantitative easing measures were needed and to be expected in the coming months, even though the Fed’s Permanent Open Market Operations (POMO)
had begun churning up a few weeks earlier
. And thus began a six-month surge in commodity prices, taking the major stock indexes higher for the ride (see Figs 1-6 below
Since August 2010, we’ve seen repeated news reports of rapidly increasing inflation measures in China and many Emerging Market (EM) countries (Fig 7
). For example:
· China: CPI
increased 283% from July ’09 trough of -1.8% to Nov ’10 recent peak of 5.1%, and is running 12% yr/yr food inflation;
· Vietnam: CPI 12.2% Jan 2011, 13.1% yr/yr food inflation;
· Egypt: CPI 10.4% Dec 2010, 18.5% yr/yr food inflation (global high);
· India: CPI 9.7% Dec 2010, 17.1% yr/yr food inflation;
· Russia: CPI 8.8% Dec 2010, 12.8% yr/yr food inflation;
· Indonesia: CPI 7.0% Jan 2011, 16% yr/yr food inflation;
· Brazil: CPI 5.9% Dec 2010, 10.4% yr/yr food inflation.
This inflation has led to demonstrations in China, as well as price fixing plans by the Chinese government, and riots in other emerging or frontier market countries, including Tunisia and Egypt of late. Many pundits, including Mr. Bernanke himself, have concluded that the commodity inflation is based on strong raw demand, and not a monetary phenomenon. These “Commodity Malthusians” as I like to call them, cite that there is simply a growing demand for too few goods, and that those goods have a hard resource limit, much like the original Malthus argument that population growth would exceed earth’s ability to sustain with its resources (“The power of population is indefinitely greater than the power in the earth to produce subsistence for man“). However, the Commodity Malthusians have not made their argument, and the evidence suggests that both monetary and trade policies have aggravated the rise in both core and commodity inflation globally.
So how do I know the last statement to hold weight? A straightforward explanation is that the U.S. has been exporting U.S. dollars for decades to other economies, buying foreign goods for consumption – the nominal cumulative total U.S. trade deficit is over $39T from 1985-2010. Furthermore, many commodities are priced and market-driven in those dollar terms. Certainly for China this is true: our trade deficit with China is near an all-time low ($252.4B in 2010, nominal cumulative $2.25T since 1995), China maintains a large holding of U.S. Treasury debt ($895.6B), and the Chinese Yuan/Renminbi is pegged to the dollar (Fig 8
). The U.S. maintains a trade deficit with many high inflation EM countries, such as Vietnam, Indonesia and Egypt, in addition to all four of the BRICs
. Some have made the overly simplistic counter-argument that since many of the EMs have a sovereign currency not pegged to the dollar, that the price increases are demand driven in these fast growing economies, especially in cases where the local currency has strengthened against the dollar. What this argument fails to factor is that commodities are all too often bought and sold with dollars, not the local currencies, and that many of these same EMs are importing a plethora of dollars from international export trade of their goods and/or from the investment dollar flow into the country from foreign interests. The flood of dollars into China and other countries has led to too many dollars chasing commodities and goods with a weakening of purchasing power – the classic definition of inflation (“always and everywhere a monetary phenomenon
,” as Dr. Friedman warned).
Much has been made about the Fed’s “pump-priming” of the economy with cheap money (target interest rates at historical lows) and its repeated use of POMO and other securities purchasing programs since September 2008. Along with the November 2010 announcement of $600B in quantitative easing (“QE2”), the Fed will have added over $1T in monetary liquidity to the markets since March 2009, and over $2T since September 2008 (Fig 9
). Money supply measures continue to increase, at least those that are still published by the Fed (Fig 10
). Where is all the money flowing? Some made its way into member bank reserves, to shore up the massive losses from the housing/mortgage and credit market crisis. But a good amount has funneled into the commodities futures and stock markets, and the timing of the injections with those market surges is evident. This isn’t a new phenomenon; markets have surged following dovish Fed monetary policy at every turn, giving rise to the S&L bubble of the ‘80s, the Nasdaq bubble of the ‘90s, as well as the early stages of the housing and commodity bubbles after the millennium, with inspiration sourced to former Fed chair Alan Greenspan. The “Greenspan Put” has morphed into the “Bernanke Put” – a play on the options term that implies a tradable floor on asset prices, as the Fed pump-primes (price fixes) to save the day with its inflation bias. The effect this has had is to continually weaken the purchasing power of the U.S. dollar, and ultimately will mean a pernicious global tax on those holding dollars and buying commodities priced in those dollars.
The CRB Index over a 25-year period (Fig 1
) is most revealing of the dynamics discussed in the last paragraph, focusing on the rise and fall of the index with dollar weakening and strengthening. Some may say there is an anomaly with the significant strengthening of the U.S. dollar from ’98-’02, but not so; this dollar strengthening was a result of a short squeeze from a crowded short trade on the dollar, even though the money supply was increasing and interest rates were kept at a relative low, and so with such qualified strength there remained a floor in commodity prices. When Greenspan opened the floodgates on interest rates to the downside in 2002, commodity prices exploded, unabated until the height of the housing/credit market bubble, followed by the rise again after Fed liquidity injections from March 2009 onward.
What has me so worried about the Commodity Malthusians is that their ever-increasing demand-driven arguments sound an awful lot like the hollow arguments made during the housing boom – that demand (and prices) could continue to increase indefinitely. Even more worrisome is their lack of recognition of demand substitution for many commodities. Though they claim many commodities will increasingly have inelastic demand, the fact is that there are viable substitutions that will change the dynamics on that inelasticity, making the demand more elastic over time 
. Of course, this won’t matter if the price levels are driven by global monetary inflation – not just from the dollar but also from other currencies that are continuously devalued via inflation-biased monetary policies. As Keynes said, in the long run we are all dead.
My guess is that this situation will end one of two ways. One, global markets will shift to recognize a new reserve currency (or a basket of currencies), and that commodities will increasingly be priced and market-driven in that measure. The bright side, and a true challenge, is if that measure follows some standard, and maintains relative stability over the course of time. The other possible outcome is that the U.S. will fix the Fed’s money printing transgressions before the stagflationary drain drags us all down too much. Commensurately, we need to address global debt and trade imbalance issues, with the U.S. held to a higher standard than continuously rolling over ever-increasing debt and unfunded liabilities that have no chance of being repaid, and that are obscured by the Fed’s “asset swap programs.” Whom are we fooling? There is no such thing as a perpetual motion machine. Those put options can expire worthless.
“Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” –Ben Bernanke, National Economists Club, Nov. 2002
Commodity substitutions can be made for many of the inflated commodities discussed. Above a certain price, it is more economical to substitute aluminum for copper in at least 20% of the applications of copper. Many rare earth metals that are deemed crucial for electronics and other specialty applications have non-rare earth metal replacements: one example is neodymium, a rare earth magnetic material that can be replaced with nanostructured iron alloys. Additionally, while it has been reported that the rare earths have supply constraints due to a Chinese embargo (China mines some 90% of the world’s supply
), China does not have the largest deposits, and rare earth elements are relatively abundant in the earth’s crust
. Agricultural commodities have many substitutions, and consumers regularly change their preferences based on supply and demand to compensate – crops can vary widely with weather, but crop utilization and capacity can also be altered. Lumber can be substituted with other building materials, such as composites. Inelasticity is a perception that changes with time and technology innovations – and can take rapid swings in the commodities futures markets with it. To the bullish speculators buying into the “commodities supercycle”: caveat emptor, and don’t forget to hedge.
 Official reports of core inflation (CPI) in the U.S. by the BLS have been consistently low over the last two years. Other independent statistical measures of CPI
suggest that the actual core rate is much higher, 5-6%, closer to current inflation reported in Brazil. Food inflation is also reportedly low, but independent year-over-year measures are anywhere from 5-15%.
 Currency devaluation is sometimes referred to as monetary debasement
. The history of monetary debasement has been discussed by economist Murray Rothbard in “What has government done to our money
Notes to Figs 1-10 : The reader is encouraged to look at the following charts: The CRB Index, first over a 25-yr period with the U.S. dollar index $DXY (Fig 1), and then over the last year, correlated with equity metal miner proxies for copper and rare earth metals (Figs 2,3) and the Dow Jones Coal Index (Fig 4). The six-month relative futures contract performance of various commodities, many of which make up the CRB Index, is also notable (Fig 5), with almost 100% rise in the futures prices of cotton, 70% in corn, 60% in palladium. Major stock indexes over the last year (Fig 6). Food prices and EM inflation (Fig 7). The U.S. and Chinese global trade balances, core inflation rate in China, the CRB Index with the U.S. dollar index, and Fed money supply measures (Fig 8). The Federal Reserve reported balance sheet showing liquidity injections and asset purchase programs (Fig 9). Money supply measures M1, M2 and M3 (Fig 10). Note that M3 has been considered the broadest measure of the money supply, and is defined as M2+large time deposits, institutional money market funds, short-term repurchase agreements and other larger liquid assets. M3 is no longer reported by the Fed , though their explanation for such discontinuance leaves one wondering why. M3 since 2006 has been estimated by various sources .
Fig 1: CRB Index vs. U.S. Dollar Index
Fig 2: CRB Index vs. FCX
Fig 3: CRB Index vs. MCP
Fig 4: CRB Index vs. DJ US Coal Index
Fig 5: Commodities Futures Price Performance Sept'10-Feb'11
Fig 6: Major Markets Performance '10-Present
Fig 7: Food Prices and Emerging Market Inflation
Fig 8: US & China Trade, China Inflation, CRB/DXY, Money Supply
Fig 9: Fed Balance Sheet
Fig 10: Money Supply