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Globalisation, commodities and inflation

London, January 2011

It may make sense for individual central banks such as the Fed and Bank of England to take commodity prices as given ("exogenous") and ignore them when setting monetary policy. But it is not true for the group of major central banks as a whole, for whom commodity-price driven inflation is very much an matter of choice ("endogenous").

Senior central bankers in the advanced economies frame their mission as controlling core consumer prices excluding food and energy items. They justify the exclusions by noting (1) food and energy prices exhibit greater volatility than other components of the consumer price index, and (2) prices are set in global markets over which any individual central bank has limited control.

If central banks reacted to every rise and fall in commodities by raising and lowering interest rates to generate an offsetting change in prices for other items it would create unnecessary volatility in output and employment. It would also confuse the beneficial signalling effects from a one-off change in relative prices (Adam Smith's invisible hand) with the pernicious effects of self-sustaining increases in the general price level and debasement of money (inflation).

But there are significant problems with the core inflation approach. It fosters policies that have externalities which are not fully taken into account by national central banks. Because of the externalities, central banks will tend to prefer policies generating higher rates of (external) commodity inflation until the rise in inflation become too significant to continue ignoring, or the resulting financial imbalances pushes the economy into recession.

In some ways an investment in commodities is simply a way to trade the policymaking gap between an increasingly integrated global economy and uncoordinated central bank responses.

UNREPRESENTATIVE CORE

Food and energy accounts for almost a quarter of household expenditure in the United States, according to the U.S. Bureau of Labor Statistics. Excluding such a high proportion of spending from the targeted inflation rate raises an awkward question about what precisely central banks are stabilising. It is certainly not the cost of living experienced by most households or the purchasing power of their incomes.

While food and energy prices remain volatile, they have generally been the fastest-rising component of the consumer price index over the last five years, with the exception of medical care. By ignoring fast-rising items while leaving in falling components such as computers, core inflation has proved a biased measure of overall price rises.

In the decade 2001-2010, a period covering an entire economic cycle, core prices in the United States rose 18 percent, while the all-items index increased 24 percent. In the most recent five year period, core prices rose 9.7 percent, while the overall index was up 11.4 percent. Core inflation has undershot true inflation by 15-25 percent over the medium to long-term.

From a statistical perspective, it is not valid to say food and energy are volatile and should be excluded from the target to avoid including too much short term "noise". Changes in core prices have not been representative ("an unbiased estimator") of changes in prices as a whole. Excluding food and energy has led central banks to systematically understate the impact of price changes on the cost of living.

To put it more formally, while commodity prices exhibit more volatility (higher standard deviation) they also exhibit a faster rate of increase (higher mean rise). It is not valid to exclude them from the consumer price index on grounds of greater volatility without acknowledging the resulting core index no longer represents the true cost of living.

FALLACY OF COMPOSITION

By ignoring the effect of rising food and energy prices central banks are also guilty of the fallacy of composition. The fallacy involves inferring that something which is true for a part must be true for the whole. The most famous example in economics is probably John Maynard Keynes's "paradox of thrift".

While it may be true no one central bank has much influence on commodity prices, and could justify ignoring them when considering the effect of monetary policy, the same is certainly not true for the major global central banks as a group.

Separate research by the International Monetary Fund (IMF) and European Central Bank (ECB) has found strong links between commodity prices and macroeconomic variables including global industrial output and "excess liquidity" created by central banks and other credit institutions.

In a recent working paper, Serhan Cevik and Tahsin Saadi Sedik of the IMF demonstrated "global liquidity conditions influence the dynamics of crude oil and fine wine prices. Even though this impact does not necessarily imply financial speculation in price formation, global excess liquidity - - associated with low real interest rates -- is likely to have magnified the price pressures stemming from supply / demand imbalances."

Commodity prices are exogenous for any one central bank on its own, but endogenous for the group of central banks as a whole. The more global central banks try to reflate their economies by keeping interest rates ultra-low and injecting liquidity, the more global commodity prices will tend to rise.

While economies have become increasingly interconnected as a result of trade and capital flows, central banks still think about monetary policy in purely national terms. Monetary authorities in the United States, Britain and to some extent the euro zone are focused on the need to close national output gaps. But at a global level it is not clear an output gap exists. Rapidly rising food and energy prices suggest the economy is already hitting the speed limit of non-inflationary growth.

Leading commentators such as Martin Wolf in the Financial Times and Paul Krugman in the New York Times argue the problem facing the global economy is lack of sufficient demand; the remedy is some combination of fiscal and monetary expansion. But sharply rising commodity prices suggest global growth is already hitting supply-side limits. The problem is not aggregate demand but its distribution.

Until firms significantly raise productivity, especially resource efficiency, the painful remedy is likely to involve increased competitiveness and reduced living standards across North America and Western Europe (through a combination of commodity price inflation, weaker exchange rates, higher import prices and falling real wages and incomes).

There is not much Keynesian demand management can do in the face of this sort of structural shift. Central bank policies are simply shuffling costs around (from borrowers and banks to savers and pension funds) while stoking further increases in food and energy prices.

Ends --


By John Kemp, Reuters market analyst – for Commodities Now with permission.

The views expressed are his own.