Inflation and Commodity Prices
Last week, amid a stream of bearish economic news, the chairman of the Federal Reserve, Ben Bernanke, asserted his priority on price stability and uttered the word “dollar,” as if turning a new leaf.
He did that to get your attention.
Fed chairs rarely ever say that word, for reasons that Greenspan learned on his first days in office back in 1987 — the same reasons that CEOs rarely comment on their stock’s valuation.
Bernanke’s original remarks came before Friday’s unemployment report rained on Wall Street.
But just in case anyone thought the weak report might have softened his stance over the weekend, on Monday, he repeated his determination to tackle increases in long-term inflation expectations, and to fix the dollar. The rhetoric helped boost the currency and splashed cold water on gold’s recovery.
I say “helped” because the Saudis did most of the work by announcing an output hike (500,000 bpd).
Let me tell you right out of the gate that, as a rule, the Fed talks tougher than it is capable of acting, especially with a new administration around the corner. Bernanke has nothing more in mind than taking away the interest rate stimulus, as Greenspan did after 2004 — gradually and marginally…if that!
What’s more, the consensus doesn’t expect any action near term. Even more crucially, ultimately, his resolve rests on the correctness of his premise that the risks to economic growth have abated.
The Fed is not ideologically equipped to tackle the duality of rising unemployment and rising prices. Do you really think it is going to hike rates while stocks are reeling?
No. It just assumes that won’t be happening at the same time that prices are generally still rising.
But what is most important to understand is the factor that stirred the hawkish rejoinder.
For it is obvious that the Fed is reacting to market sentiments. And those sentiments are what I want to bring to your attention.
Is This the Crackup?
Back in March, oil prices were just breaking through $100, and the Fed hinted that it was probably finished cutting interest rates. Investors started looking for a big commodity and oil price correction.
It wasn’t to be.
Oil continued charging higher, egged on by bullish calls from America’s biggest investment dealers.
It is now backing off a high of about $139 in the nearest futures contract. That’s up 40 percent in three months, 100 percent in 12 months and nearly 200 percent in fewer than two years. It’s up more than 1,000 percent over the past 10 years. The moves in crude have been nothing short of spectacular.
On May 21, when the front month was breaking through $130, I got a call from a friend of mine — an oil analyst who runs his own investment service out of New Jersey. Like me, he’s been bullish since the turn of the millennium, but neither of us expected anything like this. Is this the crackup, he asked?
That’s the first time someone asked me if this was it…you know, “it.”
The crackup is a stage of the inflationary boom that occurs late in the cycle — when the market gets the idea that money grows on trees…and it finally abandons the idea that “prices will one day drop.”
Fear marks this final stage — in particular, of the erosion in monetary values.
It is born of a revelation, according to its author: “Finally, the masses wake up” to the fact that “inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crackup boom appears.”
However, it is the final stage of the boom. It is relatively short. It could last days, weeks, maybe even months, but the author (Mises) did not have much more in mind than that.
It is literally the death of that particular money.
Importantly, Ludwig von Mises concludes, “If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds.”
The laws of supply and demand determine money’s value, as with anything else. And if the supply of something is unlimited, it’s not usually worth much. So the Fed likes to downplay the fact that it can or will print money “beyond all bounds.”
I doubt we are seeing the crackup.
But we are seeing some of the things that characterize the onset of the late stages of a long-in-the-tooth inflationary cycle — in which prices rise because people expect them to rise, and the demand for money drops as confidence in the economy and the world’s common medium of exchange erodes.
As Market Focus Shifts to Money Relation…
Bernanke senses that the market is making a dangerous transition.
If I could point to one catalyst, it would be that the commodity markets are making moves that make the situation difficult to explain in terms of regular supply-and-demand fundamentals. That is, people are finally asking questions like how could the total demand for oil have doubled in just 12 months?
As Dr. Benn Steil, an economist at the Council on Foreign Relations, on May 20 stated:
“If you want to explain this terrifying apparent shortage of food that we now have in the world, I don’t think you could possibly explain it based upon enormous growth in the world’s appetite for food over the past three quarters. It just can’t be done.”
Indeed, although it was completely unrelated to this speech, the question of crack-up came the day after Steil’s speech to the Committee on Homeland Security, in which he pinned the commodity bull market almost entirely on fiat money inflation, and drew attention to gold’s relative stability as money:
“Whereas the prices of oil and wheat measured in dollars have soared over the course of this decade, they have, on the other hand, been remarkably stable when measured in terms of gold — gold having been the foundation of the world’s monetary system until 1971. It is, therefore, reasonable to conclude not that we are experiencing a commodities bubble, but, rather, the end of what might usefully be termed a ‘currency bubble.’”
George Soros’ subsequent comments last week regarding doubts about the dollar’s reserve status were like a beacon to the Fed. Undoubtedly, they provoked Bernanke’s rebuttal. For they reflect sentiments the Fed would rather discourage, as they are difficult to “control.”
For the past eight years, the big money has explained the commodity bull market in terms of events like Sept. 11, growth in Asia and other developing frontiers, previous underinvestment or the finiteness of commodities. The Fed has succeeded in discouraging the market from pointing its invisible finger at it.
But the commodity bull market is about to take on a whole new form…
June 18, 2008
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