Commodities, Inflation & QE

Who is responsible for the commodity and food inflation? Bernanke denies that it is the Fed. And, of course, the cause of inflation is hard enough to prove in a domestic economy, much less from the monetary policy followed by a central bank in a different country.

There is, however, a very unique circumstance for the US Fed. And that circumstance revolves around the fact that the US dollar is the world's reserve currency. Almost all international transactions are done in US dollars. And nearly all of the world's commodities are priced in US dollars. So, an auto manufacturer in Korea importing steel from Japan must first convert Korean won into US dollars, pay for the transaction in dollars, and the Japanese exporter, once receiving the payment, must convert the dollars into Japanese yen. So, the dollar is key to much of the world's trade.

In 2009, the Fed embarked upon quantitative easing (QE1), using a tool that the central bank had never used before - massive buying of securities in the open market and a near asymptotic explosion in the Fed's balance sheet. Last August, the Fed announced a second round of QE, called QE2. QE creates liquidity. But, because of the sheer volume of QE over the past two years, "excess" liquidity has clearly been created. "Excess" liquidity means that there is more liquidity than is needed for the smooth flow of business. The "excess" liquidity looks for the best return it can get in those places offering such opportunity, and it finds its way into those asset markets (the "excess liquidity theorem"). Bernanke points to the 25% increase in US equity prices from the announcement of QE2 in August 2010 to the end of February 2011 as evidence of QE2's success. So, clearly, the Fed intended for the "excess" liquidity to push up asset prices, probably hoping that the "wealth effect" of higher asset prices would spur economic activity in the US equity markets, which are not the only markets impacted by the "excess" liquidity. The commodity, bond and even the property markets have been impacted. Yes, property! Believe it or not, the property market in Australia took off with the implementation of QE1 in the US (see John Mauldin's new book, Endgame). But, this article is not about the equity, bond, or property asset markets. It is about the impact of QE on commodities and the food and energy inflation that it may have inadvertently, or perhaps purposefully, engendered.

At the end of February, corn and wheat prices were up 80% from year earlier prices. Soybeans were up 40%. Hog and cattle prices are at all time highs. Some of this, of course, is due to weather conditions and rising worldwide demand. As I write, WTI (West Texas) oil is over $104/bbl and Brent crude is more than $115/bbl. (I suspect the glut at the Cushing, Okla., oil terminal is responsible for the large price discrepancy.) Gasoline prices are rising daily.

Bernanke has argued that there is no "core" inflation. Originally, the concept of "core" occurred because the Fed didn't believe that, through monetary policy, it could influence food prices (weather) and energy prices (oil politics), and that these were too volatile to deal with on a monthly basis. But, now, "core" has morphed into a political concept to insure the American voter that inflation isn't an issue. Be that as it may, America still spends a significant percentage of its income on these items. Of more importance, third world and emerging nations spend more than 50% of their incomes on food and energy.

So, let's not fool ourselves. The unrest in the Middle East has a lot to do with food and commodity prices, and Fed QE policies may have a lot to do with those prices. Here is how the "excess liquidity theorem" works:

  • The Fed lowers interest rates to 0% and embarks upon QE;
  • Institutions and investors, holding the "excess" liquidity, look for and find higher yields in emerging and other "opportunity" markets;
  • That capital inflow fuels those economies and drives up the demand for resources and commodity inputs;
  • Speculation in commodities adds to the demand and prices continue to rise;
  • The emerging economies have two choices - they can peg their currencies to the dollar (like China) to protect their export markets and suffer inflation in their economies, or they can try to neutralize the dollar inflows via higher interest rates, thus slowing their own expansions and, perhaps, impacting their employment levels.

Let's look at what happens when a country, like China, pegs its currency to the dollar. Bernanke is correct when he claims that China wouldn't have the inflation problem they have today if they allowed their currency to float. Here is the logic: Because the dollar is the world's reserve currency, Chinese exporters receive dollars for their export products. Since they are not allowed to exchange those dollars for their local currency (renminbi) in an open market, they sell it to the Chinese Central Bank at the pegged exchange rate. The Chinese Central Bank has to print renminbi to purchase the dollars. So, the Chinese Central Bank ends up with dollars, but has printed an equal value amount of domestic currency. It is likely that, if the Chinese currency were allowed to freely float in the forex markets, inflation in China would subside. So would their exports and their GDP - and probably their employment levels.

Now let's look at what has happened in countries with freely floating exchange rates, especially with regard to commodity prices. The first table show the changes in the price of commodities in the home currencies (i.e., the cost of commodities in the local currency), of seven selected freely floating currencies for 2009 and 2010 as measured by the price of RJI, an exchange-traded note that mirrors the movement in the price of the Rogers Commodity Index. The second table shows the expense/revenue ratios of the governments sponsoring those currencies as measured by data found in the IMF World Outlook database, October, 2010. Each table also shows the rank from best to worst in the change in commodity prices in the home currency in the first table, and in the expense/revenue ratio in the second table.

Year

% Chg RJI

USD

% Chg RJI

AUD

% Chg RJI

CAD

% Chg RJI

BRL

% Chg RJI

JPY

% Chg RJI

CHF

% Chg RJI

GBP

2009

34.0

-1.5

16.4

4.0

35.0

23.9

26.9

2010

26.3

17.3

21.4

20.2

15.9

18.1

28.5

Rank

7

1

3

2

5

4

6

Year

(%)

Exp/Rev

USD

(%)

Exp/Rev

AUD

(%)

Exp/Rev

CAD

(%)

Exp/Rev

BRL

(%)

Exp/Rev

JPY

(%)

Exp/Rev

CHF

(%)

Exp/Rev

GBP

2009

142

112

114

109

135

96

128

2010

141

114

113

105

132

103

128

Rank

7

4

3

2

6

1

5

Note: USD=US dollar; AUD=Australian dollar; CAD=Canadian dollar; BRL=Brazilian real; JPY=Japanese yen; CHF=Swiss franc; GBP=British pound

Note that, except for Switzerland and Australia, the ranks between changes in commodity prices and government deficits show high correlations.

In those countries following excessively stimulative economic policies, as measured by the expense/revenue ratio, including the US, the UK and Japan, commodity inflation appears to be explained by internal policies. But, commodity inflation in the other four countries, especially Switzerland and Brazil, appears to be much higher than internal policy would imply. For example, commodity inflation in Switzerland is more than 40% over the two year period while their budget was nearly balanced. Brazil has complained about the explosion of US dollars since the Fed began QE. Yet, Brazil's relatively low deficit levels were still associated with much higher commodity prices, especially in 2010. The same appears to be true in 2010 for Canada, and to a lesser extent, in Australia.

The data backs up the "excess liquidity theorem" that the "excess" liquidity of US dollars, as manufactured by QE, seeks opportunity elsewhere in the world. Since, the economies of the US, the UK, and Japan offered little opportunity, commodity inflation in those economies could be explained by internal extremely stimulative economic policies. The "opportunities" for investment of the "excess" liquidity existed in the other four economies shown. And, while the data here do not directly implicate the Fed for commodity inflation in those countries, they do back up the notion that when the world's reserve currency central bank generates "excess" liquidity, those excesses have unintended consequences - in this case, a high probability of contributing to commodity inflation.

Robert N. Barone, Ph.D, is is the CEO of Ancora West Advisors LLC, a registered investment adviser with the Securities and Exchange Commission of the United States based in Reno, Nev.

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