London, 24 February 2011

Commodities Now: The global economic outlook is beginning to look grim as inflationary pressures accelerate and growth headwinds mount. Effective oil prices (including refiners' margins for products such as gasoline and distillate) have risen well above $100 per barrel in response to strong demand from emerging economies and escalating unrest in the Middle East.

Most forecasters employ a rule of thumb that every $10 price increase trims global growth around 0.5 percent over the next twelve months. Spot prices for both Brent and West Texas Intermediate (WTI) have risen $20 per barrel since November, which could slice 1 percent off predicted growth in 2011 if price rises are sustained.

International Energy Agency (IEA) Chief Economist Fatih Birol this week warned oil prices were in the danger zone and pose "a serious risk for the global economic recovery". Executive Director Nobuo Tanaka was even more blunt, warning the burden on consuming countries could trigger a repeat of the crisis in 2008.

BROAD COMMODITY INFLATION

Inflationary pressure is not confined to energy. Cocoa prices have hit their highest level for 32 years, while Arabica coffee is at its highest level since 1977, and cotton has also hit multi-decade highs. Wheat and corn are back to levels recorded during the food crisis of 2008.

Industrial metals copper and tin have hit record highs in recent weeks. BHP Billiton this week forecast iron ore prices would remain high for at least the next two years. Chief Executive Marius Kloppers noted "Simply put, over the next 12, 18 months, perhaps two years, there's not a substantial amount of new capacity coming on, and it's more an issue of the supply side than the demand side."

Price rises are now more widespread than at any time since the first half of 2008. No fewer than 30 commodities were reported up in price during January, according to the monthly survey of purchasing managers conducted by the Institute of Supply Management (ISM) in the United States.

Increases were recorded in all sectors from energy (diesel, fuel oil), to metals (aluminium, copper, brass, steel), chemicals (caustic soda, plastics), packaging, freight, and farm products (nuts and sugar). No commodities were reported down. Net increases covered more commodities (30) than at any time since August 2008:

http://graphics.thomsonreuters.com/ce/ISM-BALANCE.pdf

Central bank officials in North America and Western Europe and some observers take comfort from the fact pressures seem confined to the early stages of the supply chain. Many argue the global economy is witnessing a shift in relative prices rather than broadly-based inflation. But this may be a false comfort.

While manufacturers and retailers have struggled to pass on the full extent of rising raw materials costs in the United States, they have been much more successful elsewhere. Even in the United States, there are clear signs inflationary pressures are starting to spread down the supply chain.

There is some sign that both core producer price inflation and core CPI have passed the low point for the current cycle and are starting to accelerate:

http://graphics.thomsonreuters.com/ce/CORE-INFLATION.pdf

TIGHTENING CYCLE COMMENCES

So far the Federal Reserve and other major central banks in the advanced industrial economies have sought to look past increases in commodity prices and headline inflation to focus on relatively benign levels of core inflation -- trusting high unemployment and the implied output gap will ensure rising commodity prices do not filter through into broader and self-sustaining upward pressure on prices and wages.

But such confidence may be fraying. Senior officials at the European Central Bank have signalled the need to remain vigilant about second-round effects from increasing raw material prices. At the Bank of England, three of the nine members of the Monetary Policy Committee voted to raise rates this month.

While dissent within the Fed has become quieter, it seems unlikely the U.S. central bank will extend its asset purchase programme (QE2) when the current round is completed in June.

It is increasingly certain the easing cycle is over and the next move in all major economies will be to make monetary conditions less accommodative. Benchmark bond yields have already risen steeply as the market factors in future rate increases.

Emerging markets and commodity producing countries are much further advanced in the policy cycle as they fight rising inflation. The People's Bank of China has raised deposit rates for the third time since November, and boosted banks' required reserves no fewer than seven times since the start of 2010 to drain excess liquidity and restrain credit expansion.

Central banks in other emerging markets such as Brazil and India; commodity producers such as Norway, Australia and Canada; and small open economies like Sweden have all warned about mounting inflation and started to increase lending costs.

While key leaders such as Fed Chairman Ben Bernanke and Bank of England Governor will try to postpone tightening as long as possible to give the recovery more time to consolidate and reduce the "persistent large output gap" (PLOG) further increases in inflation could force their hand. Continued monetary ease depends on commodity prices stabilising.

If monetary policy is at the start of the tightening cycle, fiscal policy is far more advanced. The major economies have ended fiscal stimulus or in some cases begun to focus on deficit-reduction.

WORSENING POLICY TRADE OFF

Policymakers and bullish investors are relying on emerging markets and cash-rich corporations to pick up the slack, driving the next phase of expansion with consumer-led growth in Asia and investment-led spending in North America and Europe. But rising inflation and input prices pose a risk to both the hoped-for engines of growth.

Policymakers and many commentators (especially those with Keynesian inclinations) continue to assume risks to growth/unemployment and inflation are exclusive. In particular, they argue persistent underemployment in the United States and Europe imply the existence of a large output gap that will prevent commodity prices becoming embedded in inflation and expectations.

But there are reasons to be sceptical. Output gaps may prove smaller than assumed if unemployment and low capacity utilisation contains a large structural component and some capacity has effectively been lost forever. In any event, the relevant measure of spare capacity is arguably global rather than national, and in raw materials rather than manufacturing. It is not obvious that there is a substantial margin of spare capacity of raw materials on a worldwide basis.

The biggest risk is a re-run of the stagflation of the 1970s if central banks continue to stoke demand through low rates while the supply remains tight owing to decades of underinvestment, the monopolistic structure of many extractive industries, mounting unrest in key commodity producing regions and the anticipation of further price rises by investors.

Ends --

By John Kemp, Reuters market analyst - for Commodities Now

The views expressed are his own.