London, 17 May 2011: Reuters

Establishment economists and policymakers dominating central bank policy committees have a curious blind spot when it comes to commodity prices. Prominent economists ranging from Fed Chairman Ben Bernanke, Vice-Chairman Janet Yellen and New York Fed President William Dudley to former Vice-Chairman Donald Kohn, Bank of England Deputy Governor Charles Bean and Nobel Economics Laureate Paul Krugman all insist rising food and fuel prices are not a sign of excess demand and have nothing to do with macroeconomic policy.

In their view, rising prices are a microeconomic phenomenon. Price increases in those markets are driven by unique supply and demand factors and have no broader significance. As long as spare capacity, high unemployment and stable expectations prevent commodity prices from sparking a wage-price spiral, commodity markets have no bearing on interest rate policy.

DIAMOND IN DIFFICULTY

This view was most recently on display when Fed nominee Peter Diamond told his confirmation hearing before the Senate Banking Committee, "I view commodity prices as driven by micro factors, not general stimulation of the economy."

Diamond's nomination has already been blocked twice. His answer on commodities has not improved his chance of being third-time lucky. The Banking Committee voted to send his nomination to the Senate floor but divided 12-10 along party lines. Senator Mike Johanns of Nebraska, the only committee Republican to support Diamond last year, withdrew his support, complaining, "We must be increasingly wary of the threat of inflation, yet the Fed continues to print money with reckless abandon."

Senator Richard Shelby, the ranking Republican on the committee, was even more blunt: "I believe he is an old fashioned big government Keynesian".

Diamond is not the first senior policymaker to be assailed about the rising cost of basic necessities. In a question-and-answer session in March, the New York Fed's Dudley was asked by a member of the audience, "When was the last time, sir, that you went grocery shopping?"

His attempt to point out other, less visible items such as consumer electronics that were falling in price backfired and drew a sharp retort: "I can't eat an iPad".

DIALOGUE OF THE DEAF

The Fed insists its policies including ultra-low interest rates, a $600 billion round of asset purchases and the accumulation of excess bank reserves have nothing to do with the renewed surge in commodity prices over the past eight months.

But most congressional Republicans and some of the public blame Bernanke and his colleagues for sparking a rally that has cut living standards for households, since food and fuel prices are rising much faster than income.

It has led to a damaging stand-off that threatens to undermine the Fed's political independence and its credibility with voters. Diamond's nomination has languished in limbo for months. Unfilled vacancies have cut membership of the Fed's Board from seven to five -- the minimum it needs to make emergency lending decisions. Bernanke's reappointment in 2014 threatens to be controversial.

FED: IT'S NOT OUR FAULT

Senior Fed officials and other establishment economists have tried several defences to disclaim responsibility for rising commodity prices -- none of them very convincing. Yellen has argued, "recent developments in commodity prices can be explained largely by rising global demand and disruptions to global supply rather than by Federal Reserve policy".

She singled out emerging market demand as well as concerns about oil production in the Middle East and North Africa, droughts in China and Russia and other weather related disruptions that have contributed to the jump in food prices.

www.federalreserve.gov/newsevents/speech/yellen20110411a.htm

But while Yellen dismissed financial factors as unimportant, she ignored the run-up in speculative long positions, which has coincided with the second round of bond buying, and did not explain why quantitative easing would affect the price of financial assets such as equities, bonds and the dollar, but not real assets such as commodities.

DUELLING DEAD ECONOMISTS

The second line of defence has been to deny the importance of macro factors altogether and insist prices are set in a highly orthodox microeconomic framework of supply, demand and inventories, possibly with a hyper-rational, forward-looking component.

The Bank of England's Bean deployed this argument when quizzed about rising oil at the press conference to present the bank's latest inflation forecasts. Bean relied on the theories of long-dead economists Harold Hotelling and Holbrook Working, who argued spot and forward prices were driven by a strategy of optimal reserve management and revenue maximisation. But while Hotelling's model is elegant, it has little or no explanatory power in the real world of lumpy investments, uncertain reserves and wildly fluctuating demand and prices.

Like other policymakers, Bean seemed at a loss to explain short-term price volatility, especially the crashes in the oil market on May 5 and 12. Gyrating commodity prices are one reason the bank's own macroeconomic forecasts keep going wrong.

Once commodity prices become forward-looking and expectations enter price determination, commodities become subject to the same "animal spirits" as other asset markets, as John Maynard Keynes, another long-dead economist, could have explained.

QUESTIONABLE ECONOMETRICS

The third strand of defence has been to argue that there is "no evidence" that the influx of investment money has affected commodity prices and to cite a battery of econometric studies, which could not identify a clear statistical link between commodity long positions and price rises, especially during the earlier part of the decade.

But absence of evidence is not evidence of absence. Given the relatively poor and incomplete data on commodity investments and the complex, non-linear links between speculation, fundamentals and prices, it is not surprising econometric studies have not produced a "smoking gun".

Lack of a clear link may say more about the limitations of the econometric techniques than how prices are determined. In any event, evidence is mixed. Some studies by the IMF, ECB and professional economists have found links between commodity prices and macroeconomic variables such as global liquidity.

The current consensus has softened from a position that there is no evidence of speculative impact and that supply and demand account for all observed price changes to a more nuanced position, in which supply and demand determine the direction if not the full extent of price changes.

"The available evidence illustrates that oil price movements between 2003 and 2010 are largely explicable in fundamental terms, even if it is impossible analytically to determine whether those movements were precisely appropriate in fundamental terms, or to some extent also influenced by financial investment flows," wrote Adair Turner,

Jon Farrimond and Jonathan Hill in a paper from Britain's Financial Services Authority, published by the Oxford Institute of Energy Studies.

But even they admit that oil and other commodities markets are characterised by "multiple equilibria" and a wide "range of indeterminacy", within which prices can settle. It is not clear how their fundamentals-led approach can account for recent gyrations in oil, gasoline and silver prices.

Part II: The last and most important line of defence for central bankers and economists trying to disclaim a link between monetary policy and soaring commodity prices has been to argue that the effect is probably only temporary.

Food and fuel price increases are portrayed as a one-off adjustment in response to a series of discrete and unrepeatable shocks rather than an ongoing process of inflation that signals excess demand. While they will push up the headline rate of inflation, the effect is expected to be transitory, according to the Federal Open Market Committee.

Once food and fuel prices level off, headline inflation will converge back to the core rate. This thinking permeates the Fed's thinking, and is central to the projections of the Bank of England. It was also recently articulated by Nobel Laureate Paul Krugman in a blog for the New York Times.

Much the same argument was used three years ago in February 2008, when then Fed Vice-Chairman Don Kohn promised that inflation would soon come down and argued, "This projection assumes that energy and other commodity prices will level out, as suggested by the futures markets." This was before the oil market began its final ascent to $147 per barrel.

www.federalreserve.gov/newsevents/speech/kohn20080226a.htm

Echoing this, current Fed Vice-Chairman Janet Yellen said last month, "The current configuration of quotes on futures contracts -- which can serve as a reasonable benchmark in gauging the outlook for commodity prices -- suggests that these prices will roughly stabilise near current levels or even decline in some cases."

Krugman endorsed this thinking: "The idea is that even if the recent commodity price rise is permanent, as long as it levels off it will lead only to a temporary bulge in broader inflation. And the appropriate response of the Fed is to keep calm and carry on."

http://krugman.blogs.nytimes.com/2011/05/13/commodities-and-inflation/

CIRCULAR THINKING PROBLEM

But is this argument correct or an example of circular reasoning? Ignore for a moment the question about whether it is possible to extract useful predictions about future cash prices from futures contracts, which is very questionable. The argument seems to run as follows: (1) commodity prices are determined by micro supply and demand factors rather than macroeconomic policy; (2) food and fuel price rises are one-off responses to a specific supply and demand situation rather than an ongoing process; (3) prices will eventually level out irrespective of policy, and when they do so the impact will drop out of inflation numbers; therefore (4) the Fed need not respond to rising prices because they do not signal excess demand.

The conclusion implicitly assumes the premise.

The counter-argument is that commodity prices are rising because of excess aggregate demand in the global economy and excessively loose monetary conditions transmitted from the United States to the rest of the world through the system of semi-fixed exchange rates.

Excess demand is showing up where the bottleneck is tightest, which at the moment is commodities rather than manufacturing or labour markets. By the time the Fed and other central banks have stimulated demand enough to close the gap in labour and manufacturing markets, pressure on commodities will be intense and prices will be surging.

This argument is at least as plausible as the ones advanced by Fed Chairman Ben Bernanke, Yellen, New York Fed President Dudley, Krugman and others. But if it is true, then increases in commodity prices are part of an ongoing process rather than a one-off adjustment. So long as policy remains stimulative, commodity prices will continue to rise, not level off.

In fact that is precisely what many hedge funds are expecting. Money managers have been running record long positions in crude oil and many other commodities, according to reports from the U.S. Commodity Futures Trading Commission.

MARKETS POINT TO HIGHER PRICES

Contra Yellen, who thinks the futures market is predicting prices will level off around current levels, at least half the market thinks prices will rise further. These are the very sophisticated financial investors whose hyper-rational expectations are central to theories such as those of Britain's FSA and of a host of research economists.

The "smart money" thinks commodity prices will continue rising in the medium term, promising no let-up in headline inflation.

Who is to say that the smart money is wrong? Given the deep cyclical nature of commodity markets, it would be surprising if commodity prices fell significantly as the global economic expansion matured. It is much more likely they will continue to increase if global central banks try to keep the economy on its present course.

The more the Fed and other central banks try to (over)- stimulate the global economy and make it grow faster than the available supply of raw materials allows, the longer and further commodity prices are set to rise, until rising input costs finally choke off the recovery.

In this sense, rising commodity prices are as much a product of monetary policy as the rise in equity values and the fall in the dollar. The Fed is focusing on the wrong "output gap". It should be looking at the output gap globally and in commodity markets, rather than in the United States and the labour market and manufacturing.

IMPRISONED BY THE PAST

On the question of monetary policy's role in rising commodity prices, popular opinion is basically correct, and the economics and central banking establishment is wrong. While central bankers and Keynesian economists are willing to embrace the importance of animal spirits in guiding monetary and macroeconomic policy, they cling to a strangely classical theory of commodity pricing, which leaves them largely unable to explain what is happening in the real world.

It was John Maynard Keynes who remarked, "The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood " Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist."

In this instance, progressive thinking about macroeconomic policy has been strangely allied with conservative and unrealistic theories about raw material pricing that cannot explain why prices have risen so far so quickly and are contributing to serious errors in forecasting and policy.

It is time for a rethink, with more emphasis on the real world and less on abstract theory.

Ends --

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

The views expressed here are his own.