By Martin J. Pring
There has been a lot of talk about the excessive loose monetary policy coming out of the Federal Reserve. However, most of the arguments concerning the implications take the form of generalizations as opposed to quantifiable market relationships. Our objective here is to show, through the historical relationship between short-term interest rates and the economy, that the Fed has been overly generous. Moreover, we will see that our evidence calls for much higher industrial commodity prices before this business cycle runs its course. In retrospect, future commodity prices will make today’s elevated levels look benign by comparison.
Chart 1: Commodity Prices, Short-term Interest Rates and the Economy
The bottom panel in the first chart shows our Growth Indicator, a composite economic measure that flags whether short-term interest rates should be rising or falling. Above zero readings tell us the Growth Indicator is signaling that strength in the economy is consistent with rising rates. These periods have been flagged with the green highlights on the actual three-month commercial paper yield plot in the middle panel.
The pink shading indicates when the Growth Indicator, our proxy for demand, is signaling that interest rates should be going up but instead have moved sideways or declined. The reason for that is the injection of excess liquidity on the supply side by the Fed, which has yet to conclude that inflation is the problem. In effect, the central bank is keeping rates below their natural level. The result, if you look at the CRB Spot Raw Materials in the top panel, is an above average rise in commodity prices. Compare that to the 1958 and 1981 periods when the rising black commercial paper yield indicates the Fed was ahead of the curve. At that time the result was a benign commodity rally.
The yellow shading starts when, after one of these overly generous Fed periods or pink shaded areas, the rate starts to move above its 12-month MA, i.e. the red dashed line. Yellow shading continues until the Growth Indicator moves decisively back below zero, indicating a weak economy. You can see that during these yellow periods, when the central bank is playing catch-up, commodities really start to take off on the upside. There are no exceptions.
As we approach May 2011, rates are still below their MA, and the Growth Indicator is not only in a rising trend, but at a pretty overheated level. Commodities are rising sharply and we have not even made it to the yellow zone yet. Notwithstanding intermediate corrections along the way, these conditions tell us that commodities are ultimately headed significantly higher.
Chart 2: Corporate Yield Curve, CRB Spot Raw Industrials and Growth Indicator
Click to enlargeOne of the important questions is, what does all this mean for the oil price? Chart 3 shows it overlaid with the CRB Spot Raw Industrials. There are some divergences, but in the last 10 years both series have been very closely correlated. If that relationship continues, then oil too is headed substantially higher.