Commodity Prices, Inflation and Expectations

Weakening economic growth in the U.S. as well as in other industrial countries has sapped what had been, until early this past summer, pronounced strength in commodity prices. Since then, copper prices, corn prices, crude oil and wheat prices all are down roughly fifty percent from their highs. Showing a more moderate decline has been the price of beef which is off seven percent.

The implication of these declines will clearly be to moderate future gains in consumer prices. However, not so much of a moderation should be expected. Overall, commodity prices make up roughly twenty five percent of the price of finished goods prices; more for foods but less for industrial metals. The remaining input pressures on consumer prices stem from labor and processing costs.

After rising to $142.46 per barrel this past July, WTI crude has since fallen 50% to roughly $70 per barrel. Prices have been most sensitive to the weakening in global economic growth. That weakness has been fostered by fewer miles driven in the U.S. where gasoline consumption is down 4% during the last year. Weaker oil demand is also the result of lower industrial production, off 4.5% y/y. Elsewhere, German factory production is down 0.5% y/y after 6.0% growth during 2007 and 2006; Japanese production is off 4.7% y/y after 3% to 4% gains the past two years; and French output is off 2.0% after rising 1% during the last two years.

Then there's the price of gold, reflecting global inflationary pressures. Near $700 per ounce, the price is down 30% after having momentarily touched $1,000 this past March and the price is off 6.7% y/y.

Industrial metals have weakened sharply with the weakness in industrial economies around the world. The table below indicates that aluminum prices are down 15% from their year ago level and they are off by nearly one-third from their high this past Spring. Stainless steel scrap prices also are off 11% during the last twelve months and they've halved their 2007 high. Prices for high grade copper round out the story of price weakness. They are down by more than one-half from their high this past Spring.

Food prices have shown a similar pattern of reversing past strength, helped in part by a return of favorable growing weather. Wheat prices are down by roughly one half from their year ago level and the latest is off by two-thirds from this year's high. Milk prices similarly have cratered, off by nearly one-half y/y. Egg prices (+11.2% y/y) similarly are down by one-half from their highs earlier this year. Even beef prices, which are receiving a lift from a thinning of herds in recent years, are up 5% y/y but the price is off 9% from the high this past July.All this weakness has yet to show up. however, in consumer prices for food. They have been rising at a 6.0% y/y rate after last year's increase of 4.0%. In contrast to the lower commodity prices noted above, the price consumers paid for milk & dairy products was up 4.9% y/y in September and meat prices were up 5.9%. Processing and distribution costs of food account for most of the price consumers pay -- and they have not fallen, only their rate of growth has slowed.

How does all this shake out for the U.S. economy as a whole? The Federal Reserve can take comfort from lower product prices as it eases monetary policy. Inflationary pressures generally are under control. The core CPI rose at a 2.5% year-to-date through September, roughly its growth rate over the last two years. Moreover, oil prices have more than halved their highs early their summer.

Inflationary psychology, however, is a different story. One measure of that psychology is the difference between the yield on long term U.S. treasury notes and the Federal funds rate. That difference has risen sharply over the last year. The markets are indicating a worry about future inflation. Growth in M2 recently rose to 6% y/y from its low of less than 4% during 2005. The monetary base has surged. Both have occurred as the Fed has provided liquidity to deal with the current crisis in the financial markets. Will this provision justify the concern about the potential for higher inflation? The monetary theorist would say "probably not," because the demand for money is collapsing. In fact, another direct measure of the market's inflation psychology is the implied forward inflation rate suggested in the market for Treasury Inflation-Indexed Securities (TIPS). It has dropped to 2.2% from 2.5% during 2006. Will a steep yield curve anticipating higher inflation eventually be reconciled with the decline in the forward rate in TIPS? Yes, but the direction of inflation will depend on how long the Fed keeps money easy after the current financial crisis is resolved.

The commodity price series in the table below can be found in Haver's WEEKLY database. The monetary and inflation figures cited above are available in USECON.

Creative Destruction and Aggregate Productivity Growth from the Federal Reserve Bank of Philadelphia can be found here.

Oil Prices and Inflation from the Federal Reserve Bank of San Francisco is available here.

Euro Area industrial output (IP) fell sharply in October dropping by its largest amount in over five years. In Sept MFG IP is dropping across all major product groupings just as it did in August and nearly did so in July. In the EMU the drop in IP has become intense, widespread and persistent. Across the largest EU/EMU countries IP also fell in Sept with the exception of Spain where numbers are more volatile than resilient. Spain in fact has the deepest decline in IP for Q3 at a -14% annual rate. Indeed, Germany, France, Italy and the UK all have drops in IP in Q3 as well. It is pretty clear that with declines of this magnitude (apart from Spain’s larger drop) ranging from -2.7% to -5% these economies are in recession or heading there soon.

In Germany the wise men issued a statement urging more public spending to boost the economy and urged the ECB to cut rates as much as it could see its way to do. They predict a recession in German for 2009, based on a wide variety of metrics. .

Similarly the Bank of England in a statement issued on the day said that the UK economy has probably entered recession in the second half of 2008. It does not see GDP growing until the second half of 2009. It sees inflation falling relatively rapidly.

Assessments of the economy in Europe are being cut rapidly. Evidence on the economy is that growth is fading fast. In this environment oil prices are sliding on the weakness in global demand even with some OPEC output cuts having been announced and with China having unveiled a better-than one-half of one trillion dollar stimulus plan. China further announced that as part of that plan it would implement export tax rebates and cut taxes on some export items. In July the government had implemented some export tax breaks for the garment industry. While China portrays some of these as factors to ‘stimulate domestic demand’ it seems that these really are efforts to keep getting a chunk of foreign demand at a time that the size of that pie is shrinking or at least growing more slowly. China’s ‘stimulus’ may not be as helpful to the rest of the world as it thinks.