Deflation Fears Withering as Commodities Rise
By Caroline Baum
New York, Dec. 16 (Bloomberg) -- Commodity prices have been quietly rising, which is inconsistent with the prevailing view of a world economy mired in the doldrums with a deflation threat lurking around every corner.
Some of the increase -- in oil and gold prices, for example -- can be explained by the potential for war with Iraq: oil, because of fears of an actual disruption in supply from the Middle East compounded by a strike in Venezuela; and gold, because of its crisis appeal.
Even outside of oil and gold, commodity prices are moving higher. The intense focus on deflation -- the ``D'' word merited two mentions in the minutes from the Federal Reserve's Nov. 6 meeting -- is unwarranted given the stirring in raw industrial commodity prices, which suggests the worst is behind us.
The CRB spot raw industrial price index, which includes such things as scrap metals (copper, steal and lead), cotton, rubber and hides but no oil or lumber, is at a 21-month high, up 16 percent since hitting a 15-year low in November 2001. As the name implies, these commodities have industrial applications. Short of a disruption to production, changes in the prices of these key raw materials tend to be demand driven.
That doesn't mean an increase is inflationary, as Federal Reserve Chairman Alan Greenspan is quick to remind us. A rise in commodity pries is only inflationary if the central bank accommodates the increase, printing sufficient money to prevent the price of something else from falling.
Profit Precursor
While the increase in commodity prices from depressed levels still pales in comparison with other commodity cycles, it suggests better times ahead, according to Joe Carson, an economist at Alliance Capital Management.
``Ongoing gains in commodity prices are important not only because they speak of better and broader economic gains, but also because they have been associated with relatively strong profit cycles,'' Carson says. ``History shows that companies need to see some price recovery before they feel confident enough to add to inventory levels and begin hiring again.''
Carson defines a commodity price cycle as one that has magnitude (double-digit percentage gains), breadth and duration. Only the first two have been satisfied so far.
How can that be? Global demand is weak yet raw materials prices, which are sensitive to changing demand, are behaving as if economic growth is strong.
Demand Indicator
``Commodity prices tell us about demand, but they also tell us about a secular shift in economic leadership, a change in the marginal buyer,'' Carson says.
In 1998, commodity prices collapsed along with demand from Asia, which was working its way through a major economic and financial crisis. Strong growth in the U.S. and Europe couldn't stem the slide in materials prices.
Now, commodity prices are accelerating in conjunction with modest growth in the U.S. and anemic growth in Europe.
``It tells us some parts of the world, like non-Japan Asia, are stronger than we thought,'' Carson says. China, for instance, is experiencing ``strong goods-related growth while the developed economies are increasingly reliant on services.''
The rise in commodity prices tells us something else, according to John Ryding, chief market economist at Bear, Stearns & Co. ``It's a signal that monetary policy is accommodative. The talk of deflation is completely misplaced.''
Historical Precedent
The parallels between the current period and the one from 1992 to 1994 go beyond the jobless nature of the recoveries.
``In 1993, everyone was suckered into the steepness of the yield curve, lulled into complacency about the Fed,'' Ryding says. ``The bond market built up tremendous leverage'' on the assumption that interest rates would never rise.
The same sort of complacency exists now about the Fed, no doubt inspired by the central bank itself.
``It's difficult for the bond market to get too beared up ahead of any Fed action to raise rates,'' Ryding says. ``By the time people figure out the fundamentals behind the rise in commodity prices, it will be too late.''
A combination of accommodative monetary policy, stimulative fiscal policy -- more tax cuts on the way -- and strong productivity growth ``ought to add up to more robust economic growth next year,'' Ryding says. (One could have said the same last year.)
In addition to rising commodity prices, Ryding points to the spread between nominal gross domestic product and the overnight federal funds rate as another sign monetary policy is accommodative. (The funds rate can be viewed as a proxy for the cost of financing, while GDP growth represents the return on investment for the economy at large.)
With the gap between the 1.25 percent funds rate and the 4 percent year-over-year nominal GDP growth the widest since 1992, it wouldn't be too much of a stretch to see the cycle resolve itself in the same way as the earlier episode. |
