Commodity prices have moved sharply higher over the last several months, leading to increased worries that the Fed is “behind the curve,” “debasing the currency,” or “monetizing the debt.” Such fears are based on a poor understanding of the inflation process and how the Fed conducts monetary policy.

No doubt, prices of raw materials have risen. There are some basic reasons for this. One is the global growth story. Increased demand from China, India, and others will put upward pressure on commodity prices. Commodity prices are also a function of interest rates. Low interest rates cause a relative increase in the value of stuff in the ground (due to lower discounting), creating less incentive for extraction, and reducing the cost of holding inventories. Perhaps more importantly, there is a speculative element, which was plainly evident in 2007 (and that speculative element is also a function of low interest rates).

 

 

A drought in Russia has put upward pressure on grain prices. The demand for food is relatively inelastic (that is, price changes generally don’t have a big impact on the quantity demanded). Hence, it doesn’t take much of a change in supply to have a big impact on food prices. China is also experiencing a drought, which is likely to keep wheat prices elevated. However, high prices tend to encourage higher crop yields down the line.

Many are old enough to remember the Great Inflation of the 1970s and early 1980s. Having lived through that, it’s natural to be concerned that we may be about to repeat that experience. However, the backdrop is a lot different now. In the early 1970s, one out of four private sector workers were in a union. Many of those unions had cost-of-living adjustments (COLA) in their wage contracts. So, an oil price shock lifted the CPI, union wages rose, followed by non-union wage increases, and inflation quickly became embedded in the labor market. It took an induced recession by the Volcker Fed to wring inflation expectations back down. In contrast, union membership in the private sector was less than 7% in 2011 (a greater percentage of government workers are union, but they don’t have much bargaining power on wages). We’ve had a number of oil price increases over the last 10 years and none has lead to higher wage demands or an increase in the underlying inflation trend. Instead, higher energy prices tend to dampen growth.

Consumer price inflation is driven by inflation expectations, which remain well-anchored, and by the amount of slack in the economy. While the economic outlook has improved, the unemployment rate is expected to remain elevated for a number of years. Capacity utilization is rising, but remains relatively low by historical standards. Slack in production implies that we’re likely to see few bottleneck inflation pressures in the foreseeable future. For manufacturers, commodity price inflation is real. However, firms still generally have a relatively limited ability to pass higher costs along.

What role does the dollar play in higher commodity prices? Not much. Commodity prices are higher in all currencies, not just the dollar, and the dollar isn’t all that weak against the major currencies. Also, it does not matter that oil and other commodities are denominated in dollars.

What role has U.S. monetary policy played in commodity prices? Some, but not as much as you might think. In general, easier monetary policy implies higher commodity prices (see the interest rate explanation cited earlier). More importantly, think about how the Fed conducts monetary policy. Raising or lowering interest rates is meant to influence the rate of loan growth, helping to ease or tighten pressures on resources (capital and labor). Does anybody think that private-sector loan growth is currently excessive? That doesn’t appear to be the case in the U.S., but could be an issue more globally. However, that’s an issue for foreign central banks. Commodity price pressures are largely a transitory problem (food, especially), partly fueled by speculation. This isn’t the 1970s.

 

 

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