On Commodities and Inflation: Is Past Prelude to Present?

 |  Includes: CRB, DBC, GSG
by: Kurt Brouwer

Nice chart from Scott Grannis at Calafia Beach Pundit. His point is a good one, that commodities appreciate during "easy money" times when inflation is on the upswing. However, commodities do not do well when money is tight. This corresponds to my experience, both in the recent decade, as well as in the Disco Decade of the 1970s when I first began investing. Here is the chart:

Click to enlarge

(Click to enlarge)

The chart tracks the primary commodity index, the CRB, adjusted for inflation. The idea is that commodity prices tend to track money supply and inflation. This is not a perfect correlation, but it is worth considering. In other words, if you believe inflation is likely to remain pretty high, the normal response is to consider investing in inflation-sensitive commodities.

However, you also have to recognize that the Federal Reserve will eventually begin fighting inflation with higher short-term interest rates and other measures, making money tighter. When that happens, as the chart shows, commodities face tougher sledding.

Grannis covered the broader issues in this post [emphasis added]:

… Monetary policy was notoriously easy in the 1970s. Money was cheap to borrow (real interest rates were generally low), so speculators had a field day buying and hoarding commodities, and selling the dollar.

Even though inflation was taking off, the Federal Reserve did not want to influence the 1972 Presidential election by tightening the money supply so they kept money free and easy until 1973. However, we entered a recession that year and had a stock market crash along with tumbling real estate prices. There was also the oil embargo which helped usher in much higher gasoline prices. As a result, the Fed shifted gears to fighting the recession, allowing inflation to really take hold. It was not until 1979 under Fed Chairman Paul Volcker that fighting inflation became a priority and it took several years to gain control. In fact, we had double digit inflation in 1979, 1980 and 1981 before inflation fell in 1982.

As you can see, commodity prices began falling about the time Volcker began raising interest rates. Imagine that? Grannis continues:

Beginning in late 1979, when Paul Volcker took over the Fed, monetary policy shifted to inflation-fighting mode and ignored any signs of economic weakness. Real interest rates were generally high for the next two decades, and inflation fell from double digits to a mere 2%. Speculators had a hard time surviving those years, since commodity prices went nowhere but borrowing costs were high. Unable to speculate on inflation-fueled price rises, investors were forced to make money the old-fashioned way by buying and creating productive assets. Since 2002 we have seen the Fed shift to an overtly accommodative monetary policy stance. Real borrowing costs have been generally low, speculators have thrived, the dollar has again collapsed, and commodity prices have soared.

The parallels between the 1970s and the past 8 years are many: a weak dollar, soaring commodity, gold, and energy prices, real interest rates that are generally low, and a Fed pays more attention to the economy than it does to sensitive asset prices. The only thing that makes the period since 2002 different from the 1970s is that inflation hasn’t risen in recent years (although the CPI did rise to 5.6% in mid-2008). Will we continue to see very low inflation? I sincerely doubt it. History may not repeat itself exactly, but there is sure a lot of rhymin’ going on …

Here is a way to look at economic or investment threats in terms of inflation or deflation. Of the threats we face, some would be associated with a growing economy and higher demand for goods and services.

Inflationary Threats:

  • Higher interest rates
  • Resurgent inflation
  • Volatile oil and commodity prices
  • Foreign real estate bubbles

Other threats are associated with declining economy and lower demand:

Deflationary Threats:

  • Double-dip recession
  • Continuing high unemployment
  • Declining U.S. real estate prices

The U.S. Treasury and the Federal Reserve have been fighting deflation with every tool at their command and they have been pretty successful. As a result, inflationary threats are coming to the fore.

However, the aggressive actions of the U.S. Treasury and the Federal Reserve also add serious complexity to the threat picture. My advice to them is, be careful what you wish for.