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The Fed is Wrong About Commodity Prices

February 17, 2011

Author: David Weinstein

I imagine he has to say it, but Bernanke is wrong when he says US monetary policy has nothing to do with international commodity prices. At the height of the Egyptian crisis, which was partly driven by rising food prices, Bernanke couldn’t say, “Oh yea, US policy economic policy is part of the problem in Egypt.” This attitude, however, is both prevalent and respected, and it’s largely wrong.

First of all, commodities as a group are not commoditized – they are not all the same. For instance, the amount of gold in the world is largely fixed relative to annual gold production. Along with its historical position as a store a value, Gold’s consistent volume about ground is a primary reason for its currency-like quality; i.e. almost entirely driven by overall liquidity. Corn production, on the other hand can vary greatly from year to year given the amount of land devoted to it and the weather. Oil is somewhere in the middle because production can vary, but the worlds known reserves are relatively fixed. The resulting differences in price volatility have been studied ad nauseam and are most simply articulated by the so-called ‘cob-web model’ (see chart below).

Very simply put: farmers, induced by high prices one year (and/or the expectation of continued high prices), plant more corn the next year, which drives down the price; only to have the farmers plant less the next year, driving the price back up…etc. Given this clever model, I can see why most economist feel monetary policy is not relevant, or at least a far less important factor.

It stands to reason, however, that in all instances, more money for any given level of production means more dollars per unit; i.e. a higher price. It’s just another way of saying, “Inflation is always and everywhere a monetary phenomenon…” (Miltion Friedman). A recent article about booming farm land in the US sheds light on one of the mechanisms though which ‘extra’ dollars feed into higher prices.

The price of farm land in the US feeds directly into the supply curve for agricultural production. The chart below shows, in very simple terms, a farm in the US will have to earn a higher price (and produce less) for any given level of production because his supply curve has shifted (S1 to S2).

Well, one can ship corn and wheat around the world, so higher prices in the US, quickly translates into higher prices elsewhere. Why ship your product to Europe or Egypt if you can get a higher price here in the US? Less wheat shipped to Europe and the Middle East, reduces supply locally and lifts the local price. More broadly, all the inputs into the cost of production exacerbate this phenomenon. Higher oil prices means it’s more expensive to run the tractors…etc.

What, Bernanke would ask, about exchange rate? High inflation in the US means a weak dollar given foreign buyers an advantage. This might be true, if only the dollar would actually go down! Against it’s major trading partners, the USD has been stubbornly strong! Remember deflation in Japan and the banking train wreck in Europe? Not to mention, the seemly endless flight-to-quality bid in the treasury market.

Yes, many of the emerging economies subsidize food, leading to market dislocations. And, many Asian countries have intentionally held back the appreciation of their currency, leading to local inflation. (And why is capital flying out of the US into Asia? Massive monetary expansion, perhaps?) However, these things are true in any market condition. They do not change the fact that higher prices in the US, lead to higher prices everywhere. Increased globalization means everything is global. Not just Facebook, but commodity prices as well.

By the way, if you don’t might buying in after a long run up, you could play this agricultural bull market with companies like Monsanto (MON) and Dupont (DD).

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