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Monday May 15, 2006 - 10:24:30 GMT
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Economics Weekly: Why recent commodity price rises are not inflationary

Recent commodity price rises are difficult to justify…
In the past few weeks, commodity prices have scaled new record and decade highs, prompting other buyers to come on board citing strong demand from the emerging markets as a reason for expecting further increases. However, our view remains that, increasingly, commodity prices are being divorced from the reality of stronger fundamental economic demand. Commodity prices are therefore vulnerable to a correction, but with global liquidity still buoyant they may rise further before they fall back, likely very sharply. This week’s economic briefing looks at whether there is any real risk of consumer price inflation accelerating as a result of the recent sharp rise in commodity prices, concluding that there is a risk but that this is minimal so long as monetary policy is anti inflationary. In this sense, bond markets are probably correct in not pricing for greater inflation risk and that commodity prices are vulnerable to a correction.

…with some of the increase likely to be down to speculative activity
This is not an argument that suggests commodity prices will fall in the coming decade below the level seen in the last 15 to 20 years - they will remain higher in our forecasts – but rather that currently commodity prices are moving too far above actual commodity demand. One possible reason is that strong growth in global liquidity - as can be seen in the form of historically low global interest rates, both short term and long term, elevated equity markets, strong bond prices (even after some correction recently) and hence fast growth in global money supply – is boosting investments in these commodities through the availability of financial market instruments. In short, speculative activity or a belief that commodity prices can go higher is partly behind the recent surge.

Growth in the emerging markets does not seem enough justification for recent increases
But why do bond markets remain so indifferent in the face of the recent sharp rise in commodity prices? As chart a shows, bond market yields remain low even though commodity prices are rising at their fastest pace since the 1970s when annual price inflation was running in double digits. This is despite the fact that chart b suggests commodity price rises are associated with price inflation. This implies a belief that bond markets do not think price inflation will accelerate this time. One possible reason why this may be the case is illustrated in chart c. In the 1970s and 1980s, sharp rises in commodity were not as associated with faster economic growth as they are today. In other words, the rise in the price of commodities that we are currently experiencing is partly explained by the fact that greater demand, particularly from the emerging markets, justifies some of the increase. And this is more the case in the current decade than in the preceding decades shown in chart c. Indeed, the charts suggest that historically the best explanation of rising price inflation is economic growth, not commodity prices. Bond markets seem to be reflecting a belief that monetary policy will remain tight enough to control growth and so curb any inflation.

Companies cannot fully pass on increases in their costs to consumers...
Chart d shows that while firms’ raw materials costs are closely correlated with commodity prices, they cannot currently pass on these increases to customers, so it does not show up in consumer price inflation, see chart e. In the current decade, falling goods price inflation is a bulwark against commodity price inflation feeding through into domestic consumer prices. Low goods price inflation as shown in chart e (here, the UK is used as an example) is reflecting international competitive pressures and the resultant lower price of tradeable goods. In the UK (and elsewhere) this global deflationary pressure is acting to offset the impact on consumer price inflation of the increased costs of firms’ raw materials, leaving them with little capability to increase their output or factory gate prices. More open global markets than in the 1970s or 1980s means that low manufactured good prices are transmitted everywhere quickly to every trading country .

...this is helping to keep down price inflation as interest rates rise
But this does not mean that there are no risks from commodity prices, there are. It is assumed that current, global, open markets remain the norm and price pressure stays deflationary; that there is no supply shocks and that monetary and fiscal policies remain tight enough to prevent inflation returning. These are big ifs and policy mistakes could easily lead to higher price inflation. But in the event, credit conditions are being tightened around the globe, with interest rates rising in the US, EU, and soon in Japan and perhaps the UK. This means that commodity price rises are likely to cool, as speculative activity tails off and economic growth slows in response to higher interest rates. Bond markets are likely to be proved right in that there is no great upsurge of global price inflation, as commodity prices fall back closer into line with global demand. What is the size of the possible decline in commodity prices? Our calculations would suggest a 20% fall overall is possible but this could mean a drop of up to 40% for some of the fastest rising individual commodities, like copper, gold, zinc, nickel.

Trevor Williams, Chief Economist
[email protected]
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.


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