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The commodity market is holding Ben Bernanke hostage. Exploding gasoline and food prices might force the Federal Reserve Chairman to raise interest rates despite his fears that the economy is too weak to stomach it.
The Standard and Poor’s Goldman Sachs Commodity Index, an energy-heavy measure of commodity prices, is up about 43% from a May 25, 2010 lull and has risen approximately 17% from one year ago. The price of gold, a component of the index, has advanced more than 29% year-over-year.
Many analysts and economists believe that this rise in commodity prices – particularly in the areas of energy and agriculture – will lead to widespread inflation among all goods and services. After all, American commerce depends heavily on oil and gasoline to move people and products from destination to destination. It is only common sense that more expensive oil will ultimately drive up prices as businesses pass on their higher costs to consumers.
However, we disagree with some analysts who anticipate continued commodity inflation as far as the eye can see. We fear that a sustained rise in food and gas prices will stall the nascent recovery, leading to another economic slowdown that would itself drive down commodity prices. Just think back to June of 2008, when $147-per-barrel oil helped spark the ensuing financial crisis and Great Recession.
Now more about Ben Bernanke… Before entering government service, Mr. Bernanke was a professor of economics at Princeton University. As an academic economist, Mr. Bernanke studied the Great Depression. This area of emphasis made the Chairman particularly sensitive to deflation, or a decrease in price levels.
In the 1920s, the United States experienced a rapidly expanding economy and as the nation boomed, so did our ability to create goods and services. Unfortunately, our debt levels also began to swell. When economic activity came to a crashing halt late in 1929, the devastation left the country with enormous under-utilized productive capacity and loads of debt.
Today, the U.S. faces a debt problem, but we face a more immediate dilemma stemming from improving capacity utilization.
Capacity utilization averaged 80.5 percent from 1972 to 2010 and is presently hovering at 77.4 percent. Although this number is somewhat low, it has recovered markedly from the 2009 bottom of 68.2 percent. When a nation has greater capacity to create goods than it has demand for those goods, deflation is a possibility.
And the current unemployment predicament is preventing demand for goods and services from keeping pace with productive capacity. With the March 2011 unemployment rate registering at 8.8%, compared to an average rate of 4.6% in 2006 and 2007, one can hardly argue that jobs are plentiful.
Bernanke is highly sensitive to this overcapacity because deflation can be an unrelenting problem that is harder to solve than inflation.
World War II broke the back of the deflationary spiral of the Great Depression in the United States. But Japan has been unsuccessfully battling deflation for more than 20 years, whereas even the Weimar Republic was able to eventually tame its runaway inflation.
As such, Bernanke’s overwhelming goal with the federal funds rate (which is nearly zero) and with quantitative easing (parts one and two) is to provide easy money as the cure for deflation.
But, this extra supply of money has led speculators to commodities as a way to make a quick buck.
So here is Bernanke’s conundrum. If commodity prices continue to rise, he will need to weigh the harmful repercussions of higher interest rates within a fragile economy against the damaging impact of higher oil prices on the American consumer.
When you fill up your gas tank, Bernanke’s decision doesn’t seem too complex. If higher interest rates can contain rising commodity prices, then what is Bernanke waiting for?
Well, many investors believe the commodity craze is transitory – that when some of the supply concerns ease (Middle East unrest, for example) prices will fall. The bond market is the best illustration of this widely held conviction.
According to John Lonski at Moody’s Capital Markets Group, the 10-year Treasury yield has averaged 7% since 1980, but today stands at a mere 3.42%. And when we analyze the implied inflation rate by subtracting the current yield on 10 and 30 year Treasury securities from their equivalent Treasury Inflation Protected Securities, we find that the bond market anticipates inflation at just 2.62% over the next ten years and only 2.77% over the next thirty years.
The commodity market is indicating runaway inflation while the bond market sees subdued inflation over the long-term. No doubt, Bernanke has found himself in quite a quandary.
We can offer Bernanke the advice of one of our favorite Yogi Berra quotes: “When you come to a fork in the road, take it.”