According to the Bloomberg article cited above, commodities are now in a bear market, defined as about a twenty percent drop from the most recent high, as the following Bloomberg chart reveals, if the most recent high is measured from April. Since early October though, prices have bounced back from their most recent lows:
Contrary to assertions that the sudden disappearance of commodities shortages are driving prices lower, is there something else that might be at play?
Money velocity can be a critical driver of inflation or deflation. The more each available dollar changes hands, effectively, the more dollars there are to chase the goods and services dollars represent, whether the money supply itself is stable, expanding or declining. Likewise, if money velocity is declining, overall prices tend to decline, no matter how much extra is added to the money supply. Here’s the book on money velocity, according to FRED, first the long-term graph, then just the last year:
- 2011:Q2: 1.664
- 2011:Q1: 1.673
- 2010:Q4: 1.681
- 2010:Q3: 1.688
- 2010:Q2: 1.690
Money velocity, after enjoying a brief surge just as the economic contraction in the Great Recession ended, has now resumed its decline, and is just now barely above the depths it plumbed during the recession. This could be a cause of the declining commodities prices, except that money velocity has been declining throughout this year and the last, while commodities prices both increased and fell. Correlation is not causation, but the lack of correlation is dispositive that there is no causation, at least so far as the market for internationally traded commodities goes.
But for domestic markets, i.e., for goods and services not priced in international markets, decreases in money velocity closely correlate with periods of economic contraction. The Great Recession saw the first decline in consumer prices in over half a century, along with a steep drop in money velocity. Declining money velocity may portend another round of demand contraction as obtained during the Great Recession, so severe that it actually caused real price declines, as the following chart indicates:
Or it may just be a hiccup along the way towards economic nirvana. Money velocity is an extremely volatile creature, and domestic prices have more than recovered lost ground (except in some particular asset classes, residential real estate, among others).
But what about exchange rates? Commodities are priced in dollars, so if the dollar loses value relative to its trading partners, that could cause an increase in commodities prices and vice versa. How has the dollar lately fared (since the April peak)? The following shows the value of the dollar against a trade-weighted exchange index:
Indeed, the dollar steadily lost foreign exchange value, up until a few months past the April peak in commodities prices, then regained lost ground for a quarter or so, then began a steady increase in late summer, just as commodities began their most significant decline. International commodities are priced in dollars, so their prices will necessarily rise and fall according to the value of the dollar relative to its trading partners. Commodity supply and demand metrics, particularly for agricultural commodities, are far more stable than their prices would indicate, because internationally-traded commodity prices inherently reflect the international supply and demand metrics of the underlying currency (dollars) in which they are priced, and currency values are highly volatile, apt to drastically change whenever a central banker blows his nose.
In essence what is happening now seems very similar to that which obtained in late 2008 and early 2009: Dollars became internationally more valuable because of their safe-haven quality in the face of economic uncertainties. This, combined with the declining aggregate demand that had forced the safe-haven influx into dollars in the first place, caused commodities to plummet in price. Aggregate demand declined so much in the US that even domestic prices declined, even in the face of massive additions to dollar liquidity. A reversal of the process in 2010 and early 2011 led commodities to retrace much of their lost ground by mid-2011. Economic uncertainties, particularly in the Euro area, are forcing a replay of the events of 2008, if at a lesser magnitude, so far.
The one truth to be gleaned from all this is that biggest factor determining price movements in commodities is not the underlying supply and demand metrics of the commodities markets themselves, but is the value of the currency in which the markets are priced.
The idea that currency fluctuations matter more in determining commodities prices is borne out by the fact that the UN World Food Price Index has decreased each of the past three months, in lock-step with increases in the foreign exchange value of the dollar. Presumably, food supply and demand are relatively stable. It is a given that the human population of the earth has not declined and is not expected to decline anytime soon. One should take no notice of the caterwauling every time the dollar plunges and food prices spike that the world is running short of food. When food prices spike higher, it is practically always because dollars are less valuable. The supply and demand for internationally traded agricultural commodities is relatively stable worldwide, increasing by about 1-2% per year, along with population growth. Prices, however, are anything but. Money supply and demand varies according to government fiat. Food does not.