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Have you noticed how the current commodity inflation smells familiar? It happened in 2008, right up to the Lehman weekend. Ags, industrial metals, everything was shooting up, with three main differences:

  • Precious metals weren't quite so hot back then.
  • There was at least a somewhat ostensible cover of BRIC growth.
  • Oil today is still far from the $150 peak set during the run.

In retrospect, what happened in early 2008 was a collusion of the following two factors:

  • A lot of smart money had sensed the coming subprime trouble and pulled out of real estate. This trend became overt and full-blown after the Bear Stearns weekend. All this money needed a place to go and nobody asked them to build up capital cushion.
  • Fed had started aggressive easing after the crash of summer 07. Whereas the global financial system had been overflowing with credit and hot money, this disastrous action by the Fed poured gas over the fire.

And the speculative, hot-money driven commodities bubble had two sad consequences:

  • People starved in some corners of the world.
  • Across-the-board rise in corporate input price slowed down global economy, thus exacerbating the severity of the crisis.

If bubbles in financial market are generally bad, it's really immoral in commodities, especially in agriculturals. Stocks go up and down; usually people lose some money and convenience but not their livelihood. But when food prices shoot up 10%, 20%, 50%, people actually starve and it's no longer an abstract number game. And it's always the poorest who feel the most pain first.

I remember clearly how I was discussing with some friends and colleagues in 08 on why the Fed would do such an evil and potentially self-damaging thing. Our conclusion was that they could get away with this travesty. They knew there'd be big trouble in housing and banking. Like a carpenter with only a hammer, they saw every problem as fixable with monetary easing. Were they aware of the speculative nature of the commodities market? They must have been. Were they aware of the destructive effect of surging commodities price on people's lives and EM economies? Being PhDs from decent departments that they are, they should have been. But I guess there was no choice as far as they were concerned. Too bad so sad, it's come down to who can take the most pain. Of course, it was the US.

Fast forward to late 2010. The Fed had been watching in horror the CPI expectation sliding down since the beginning of the year and getting perilously close to the 1% red line. As mindlessly stupid as it sounds, in retrospect the Fed has been acting as mechanical robots:

If CPI_expectation < 1% then MsgBox "PANIC!!!"
else if CPI_expectation < 2% then MsgBox "Loosen!!!"
else if CPI_expectation > 2.5% then MsgBox "Tighten!!!"
else MsgBox "Go Back To Sleep :)"
end if

There, now the Fed can use all, instead of only 80%, of its scholarly deliberation time to make scholarly jokes.

So the Fed had to do the only thing it knew how to do: QE2. And here's a brief recap of what ensued:

  • Inflation expectation reversed instantaneously. Hooray!
  • Hot money started pouring into EM.
  • Some EM -- most noticeably China, Brazil, Turkey, and some other Asian economies -- got smart and acted very quickly to fend off the unwanted hot money and inflation pressure. So far most have had at least some success.
  • Hot money tsunamied back into US, and to a lesser degree Europe. But where to go? Everything except bonds and housing -- nobody would touch housing now; that story is too hard to sell, yet.
  • Social destablization starting from the marginal economies. Sorry, to say Egyptian riots were inspired by the calling for democracy sounds really ignorant and arrogant. I know this may be hard to understand for people who have never lived through poverty, but they wanted first and foremost to be able to afford food.

Again, as in 2008, the US is still the one who can take the most pain in a World Commodities Inflationary War. We have a very solid agricultural foundation, plenty of resources (or at least easy access to them), and we can still afford to print money to keep the social welfare machine humming so that the poorest Americans will not be pissed enough to riot.

And again, the undisputed winner of this pissing contest is also pissing in the wind. The commodities bubble cannot possibly sustain, even with unlimited supply of dollar. It will have to end either when riots spread to a good part of the world or the world economy gets killed by the high commodities prices. And US economy is by no means insulated from either of the two outcomes.

What's the Fed to do then, more printing?

Actually, yes, and I say this without smug. It's really the only thing they know how to do.

Here's a summary of this scenario, admittedly a bit cynical but could very well be true:

  1. As commodities and equities keep using every excuse to go up, worries about the impact of high commodities prices on global economy and US recovery start to simmer.
  2. A trigger event, a correction, bonds surge. No, I don't think Egypt/Libya is it yet, though it has the potential if Libya keeps getting uglier for another week.
  3. Media pundits instruct everyone to think deflation. Talks of QE3 get louder by the day. Fed dissent boils over into the public arena.
  4. QE3. The dollar tanks, more surging commodities, more recession.
  5. Obama loses 2012. Bernanke gets the boot. Hoenig becomes Volcker II and, through years of painful struggle, manages to restore Fed's credibility. But I'm being irrationally exuberant here.

As I've said all along, the Japanese lost decade will look better and better as the baby boomer crisis unfolds in the US. The mindless perpetual stimulus will prove much more destructive to the economy, and the world long with it, than prudent babysteps. The problem is structural; it has to run its course. Trying to fix it with monetary policy is akin to fixing a broken crystal with a hammer.

While I've been bullish on gold, silver, and agriculturals for awhile, and pretty lucky so far, now we're back in the tricky spot we were struggling to get out in a good part of 2010, facing the same dreaded question: Will we have inflation or deflation?

My answer is yes. I'm now strictly on one-night stands. Conviction is too dangerous for the time being.


Disclosure: I am long GLD, SLV, DBA.

Source: Commodity Inflation Deja Vu