The Fed Fuels Rising Commodity Prices

Jeremy Warner Daily Telegraph October 28, 2010

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Thursday 28 October 2010

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By Jeremy Warner, Assistant Editor Published: 6:08AM BST 28 Oct 2010

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The OECD predicts that by the end of the decade, average wheat and coarse grain prices will be 15pc to 40pc higher in real terms Photo: Getty

The answer to this question, according to a recent OECD and UN Food and Agriculture Organisation report is a definitive no; global agricultural production is on track to satisfy the expected long-term increase in demand, the OECD reckons.

Yet it's little thanks to public policy, which in combination with the current craze among financial speculators for commodities, seems hell bent on driving up prices to what for millions of the world's poor may be starvation levels.

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There are two main ways in which policymakers are insidiously interfering with the usual rules of supply and demand for raw materials, and myriad different smaller ones. We'll leave aside the smaller ones, such as China's attempt to leverage its monopoly of rare earth metals for geo-political purposes, and concentrate instead on the two biggies.

One is the policy of ultra-cheap money in advanced economies to fight the economic crisis; and the other, more commodity-specific one, is massive public subsidy for the production of bio-fuels. Food is being elbowed out by pursuit of "clean fuel".

By Jeremy Warner, Assistant Editor Published: 6:08AM BST 28 Oct 2010

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As long as the US Federal Reserve remains accommodative, commodity prices are likely to keep rising. We are not yet back to anything like the extremes seen in the bubble of 2007/8. Oil prices at $140 a barrel, it will be recalled, were what helped tip the world economy into recession. Yet by long-run historic standards, both food and mineral prices are still exceptionally elevated and going higher.

The underlying reasons are well known. Rapid industrialisation and urbanisation in the developing world has created a "super-cycle" that won't ease until these countries bump up against the limits of their growth potential. Most would agree there's some way to go.

Into this already troubling mis-match between growing demand and finite supply stumbles the US Fed with a loose money policy of unprecedented proportions.

The effect of this manufactured increase in the money supply may or may not be to support domestic demand, but it certainly debauches the currency, and since many commodities are globally traded in dollars, it drives their prices higher.

For countries whose currencies are appreciating against the devaluing dollar, it shouldn't make a lot of difference; if the dollar price rises a quarter, but the euro appreciates by a quarter, the nominal price to Europeans remains the same.

But to America, to other devaluing countries such as the UK, and to Asia, which attempts with varying degrees of success to peg its currencies to the dollar, it matters a lot and is significantly inflationary.

To this distortion must be added financial speculation. Long gone are the days when commodities were bought solely for the purpose of making things and feeding the masses.

Altogether more inventive ways of leveraging these raw materials for money-making purposes have since been found. Today commodities are as hard sold as an "asset class" for investment purposes as the feed stock of bread, cars and bridges.

Quantitative easing has already sparked record inflows of money into bond funds, which is what you would expect in conditions of negative real interest rates. The inflow of funds into commodity markets - much the same sort of bet - has so far been quite modest by comparison, but it's rising fast. A study by the World Bank found "that the use of commodities by financial investors (the so-called "financialisation of commodities") may have been partly responsible for the 2007/08 spike". Just think what's going to happen once this trade gains mass appeal.

Metals are one thing, but food prices seem to be falling victim to similar influences. The OECD report predicts that by the end of the decade, average wheat and coarse grain prices will be 15pc to 40pc higher in real terms relative to 1997-2006. Reduced supply, higher feed costs and rising demand will do much the same thing to livestock prices, while dairy products are predicted to rise by up to 45pc.

In defence of these higher prices, it might be said that they do at least ration demand and incentivise investment. In any case, there's not a great deal policymakers can or indeed should be doing about their underlying cause, which is growing emerging market prosperity.

But what they should very definitely not be doing is further inflaming the situation with massive subsidies for the production of biofuels. Ever greater use of crops and the farmland that produces them for biofuel production is beginning seriously to impair food supply.

At a recent Chicago Mercantile Exchange conference, Ian Goldin, a former vice president of the World Bank and now director of the Oxford Martin School, called these policies "economically illiterate, environmentally destructive, politically short-sighted and ideologically unsound". Few outside the biofuels lobby would disagree.

And yet in the misguided belief that ethanol and biodiesel can help solve the problem of energy security in a carbon neutral manner, Europe and the US are piling on subsidy like it is going out of fashion. Existing subsidies totalling some $12bn annually would have to double again to achieve the sort of targets for biofuels that governments are setting.

Besides being inflationary for food prices, use of agricultural land for biofuels is incubating its own environmental catastrophe, from deforestation to excessive use of fertilisers and pesticides.

There is no mess, it is sometimes said, quite so bad that government intervention isn't going to make even worse. Meddling with the money supply and the use of agricultural land for fuel production might seem to be two cases in point.

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