Commodity prices have been on a tear since August and Ben Bernanke’s intimation that he’d try anything, including wholesale greenback devaluation, to get the economy moving.

Has demand for commodities dramatically expanded since August?  No, except consumers of commodities whose currencies are pegged to the dollar (China, et al) have probably (and wisely) decided to purchase more than is now needed in order to mitigate the impact of higher prices–one of the many effects of anticipated inflation. 

(Anticipated inflation causes hoarding.  When the oil embargo hit for a second time in the late seventies, it is estimated that practically every car’s gas tank stayed full or near-full throughout the crisis.   Hoarding in anticipation of inflation temporarily  increases demand, or more properly, pulls future demand into the present.  It is only a temporary effect, but can make the demand seem to have rampantly increased when what has really happened is inflation expectations have dramatically increased.  Once the hedge of buying now to use later has reached its logical end, either through decreased inflation expectations or through simply reaching the limits of supply storage, demand settles back down to become realigned with actual usage levels.) 

Commodities are doing exactly what they did in 2003 and again in 2008 in response to the Fed’s loose-money policies.  Recall that the Fed Funds rate went to 1% in 2003 and stayed there for almost two years.  Here’s what the Producer Price Index for commodities looks like over time (courtesy of the St. Louis FRED), relative to expansions and contractions (shaded areas are contractions):

Graph: Producer Price Index: All Commodities

And here’s what the Fed Funds rate has done over time, relative to expansions and contractions:

Graph: Effective Federal Funds Rate

Taking the years since 2000, there has clearly been a correlation (negative) between the interest rate policies of the Federal Reserve and the prices producers pay for commodities used in production.   Fed Funds rate increases precede a PPI decrease, and a Fed Funds decrease precedes a PPI increase.  

Since the Fed has reached the limit of decreases it can engineer in the Fed Funds rate (the rate is at zero), it has announced plans to push more money in the economy through the purchase of roughly $600 billion in Treasury obligations (quantitative easing), which adds to its already completed purchases of $1.7 concluded in the 2nd quarter of this year.  It first hinted at the new program in August.  Since then, this is how four commodities indexes tracked by Bloomberg have performed, the right scale is percentage changes:

Commodity Futures Chart

Could commodity demand have sustainably increased the 15 to 20% that price increases imply?  Looking only at oil, according to the Energy Information Agency, oil consumption increased from about 77 million barrels per day in 2000, to about 85.5 million barrels per day in 2009, increasing in volume every year except the last two.  It is expected to return to increases again this year.  Oil consumption is more or less steadily rising, but at a very steady and stable pace.  It certainly has shown no increase of 20% over the course of the last few months.  Yet oil prices have been far more volatile than quantity demanded:

Weekly All Countries Spot Price FOB Weighted by Estimated Export Volume  (Dollars per Barrel)

The same spike in commodity prices that preceded the Great Recession and the plunge in prices once into it, are represented here and in the PPI. 


The next great commodity-price spike is upon us.  It may be short-lived or durable, depending on a multitude of factors, but my expectation is that it will  play out in the third quarter of 2011.  This spike, like the two that preceded it, is the result of a spike in inflation expectations regarding the dollar, i.e., in the expectation that the dollar will decline in value.  In its initial stages, there will be an illusory expansion in quantity demanded, owing to the hoarding effect.  Ultimately, the price spike will be followed by a price plunge, as resources are misallocated to commodity acquisition and investment because of the price increase and apparent (but illusory) increase in quantity demanded, yielding an oversupplied market.  Then starts Great Recession, Part II.  Cheers.