Monday, December 22, 1997
An interesting article from Barrons to consider:
The ''D'' Word of '97
But lower prices may not indicate deflation
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<Picture: byline photo>By Michael Santoli
Key Commodity Indexes
At various times in recent years, the dreaded "D-word" that was said to be threatening global financial health was "debt," "default" or "derivatives." Now comes a new alleged assailant, deflation, which a fair number of forecasters have been warning the markets to expect in the event of an Asian slowdown.
Always in these warnings is a recitation of the recent rollover of the commodity indexes stemming from major declines in the prices of base metals, gold, lumber and any number of other materials reliant on demand from Asia's heretofore fast-growing economies. So it seems a good time to revisit the links between commodity prices and inflation or deflation.
There are several holes that can be punched in the argument for commodity-driven deflation. First, economists forever caution against mistaking a rise or fall in some prices as inflation or deflation, which represent a real increase or decline in the general price level. While a linear foot of lumber has become cheaper, the cost of an hour's labor in this country is rising and the vast service sector is posting annualized inflation near 3%.
The falling cost of a commodity, it should be remembered, is often in part just the flip side of an appreciating dollar. One way to glimpse this relationship is to peruse the Economist's commodity indexes, which the magazine compiles in terms of dollars, pounds sterling and the IMF's Special Drawing Rights. The SDR index for all items was recently up nearly eight times as much as the dollar index over the past year, and industrial-goods prices in SDR terms were down just half as much as their dollar equivalent -- a good sign that what looks like nascent deflation on these shores is largely the filtering effect of dollar-shaded glasses.
Wall Street analysts like to generate reports on the correlation of commodities with inflation, usually to show the strength of commodities as a portfolio hedge. Data on commodities' links with deflation aren't around because real deflation hasn't really been witnessed for any period since the Depression, but the inflation analyses would seem a good mirror-image proxy. Work by David Seaman at J.P. Morgan shows that the correlation over a 10-year stretch between the J.P. Morgan Commodity Index returns and the quarterly inflation rate was 0.41 (with 1 being 100% correlation) and was somewhat lower over 20 years. That means the JPMCI would be a potent hedge to financial assets, which are quite negatively linked to inflation. But it says little about the predictive power of commodity prices and inflation. Crude oil, probably the most important commodity in its final price impact, has shown a 10-year correlation of just 0.45.
Commodity indexes have proven considerably better at forecasting producer, as opposed to consumer, prices. But this isn't very helpful in figuring ultimate inflation, partly because basic materials represent a relatively small -- and shrinking -- portion of corporate expenses and their often-volatile prices are absorbed by producers far more than they are passed along to buyers. The traditional harbingers of inflation pressure and expectations, base and precious metals, together make up just 9.4% of the Goldman Sachs Commodity Index, which is weighted by each good's proportion of global output.
The Fed, don't forget, also has access to the producer price index and is always striving to intercept inflationary or deflationary forces before they reach Americans' wallets. The details of the Fed's November meeting, released last week, showed just how mindful the governors were of the Asian crisis in deciding against the inflation-fighting maneuver of tightening monetary policy.
To Peter Schiff, a broker with EuroPacific Capital who believes inflation remains the main danger, there's another flaw in the logic of deflation adherents: "One reason commodities are weak is that Asian buyers are canceling orders. These are the inputs for their export products." So while import prices here may be pressured down, there likely won't be as much imported from Asian nations where current production levels are unaffordable.
There's no denying that the washout in many commodity markets is a disinflationary event and wouldn't stand in the way of true deflation, should such a rarity occur. But the cheapening of goods in dollar terms in itself tells us little about the chances of deflation. It only represents the deflated hopes of all those commodity bulls who were sure they'd ride the wave of Asian demand to riches.
Key Commodity Indexes
CRB Group Indexes 12/19 12/12 Yr. Ago CRB Futures 233.38 235.86 245.70 Industrials 215.06 215.82 269.85 Grains/Oilseeds 213.26 218.10 215.51 Livestock/Meats 241.03 242.30 253.19 Energy 188.58 187.44 220.91 Precious Metals 246.91 243.99 254.38 Barrons ~ Bridge
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