Who is responsible for the commodity and food inflation? Chairman Ben Bernanke denies that it is the Fed. Of course, the cause of inflation is hard enough to prove in a domestic economy, much less from the monetary policy followed by a central bank in a different country.
There is, however, a very unique circumstance for the U.S. central bank. That circumstance revolves around the fact that the U.S. dollar is the world’s reserve currency. Almost all international transactions are done in U.S. dollars. Nearly all of the world’s commodities are priced in U.S dollars. So, an auto manufacturer in Korea importing steel from Japan must first convert Korean won into U.S. dollars, pay for the transaction in dollars, and the Japanese exporter, once receiving the payment, must convert the dollars into Japanese yen. So, the Dollar is key to much of the world’s trade.
In 2009, the Fed embarked upon quantitative easing (QE1), using a tool that the central bank had never used before, massive buying of securities in the open market and a near asymptotic explosion in the Fed’s balance sheet. Last August, the Fed announced a second round. QE creates liquidity, but because of the sheer volume of easing over the past two years, “excess” liquidity-more liquidity than is needed for the smooth flow of business-is clearly in abundance.
The “excess” liquidity looks for the best return it can get in those places offering such opportunity, and it finds its way into those asset markets. Bernanke points to the 25% increase in U.S. equity prices from the announcement of QE2 in August, 2010, to the end of February, 2011, as evidence of QE2’s success. So, clearly, the Fed intended for the “excess” liquidity to push up asset prices, probably hoping that the “wealth effect” of higher asset prices would spur economic activity in the U.S. Equity markets are not the only markets impacted by the “excess” liquidity.
The commodity, bond and even the property markets have been impacted. Yes, property! Believe it or not, the property market in Australia took off with the implementation of QE1 in the U.S. (see John Mauldin’s new book, Endgame). This blog is not about the equity, bond, or property asset markets. It is about the impact of QE on commodities and the food and energy inflation that it may have inadvertently, or perhaps purposefully, engendered.
At the end of February, corn and wheat prices were up 80% from year earlier prices. Soybeans were up 40%. Hog and cattle prices are at all time highs. Some of this, of course, is due to weather conditions and rising worldwide demand. As I write, WTI (West Texas) oil is over $104/bbl and Brent crude is more than $115/bbl. (I suspect the glut at the Cushing, Okla., oil terminal is responsible for the large price discrepancy.) Gasoline prices are rising daily.
Bernanke has argued that there is no “core” inflation. Originally, the concept of “core” occurred because the Fed didn’t believe that, through monetary policy, it could influence food prices (weather) and energy prices (oil politics), and that these were too volatile to deal with on a monthly basis. But, now, “core” has morphed into a political concept to insure the American voter that inflation isn’t an issue. Be that as it may, America still spends a significant percentage of its income on these items. Of more importance, third world and emerging nations spend more than 50% of their incomes on food and energy.
So, let’s not fool ourselves. The unrest in the Middle East has a lot to do with food and commodity prices, and Fed QE policies may have a lot to do with those prices. Here is how the “Excess Liquidity Theorem” works:
- The Fed lowers interest rates to 0% and embarks upon QE;
- Institutions and investors, holding the “excess” liquidity, look for and find higher yields in emerging and other “opportunity” markets;
- That capital inflow fuels those economies and drives up the demand for resources and commodity inputs;
- Speculation in commodities adds to the demand and prices continue to rise;
- The emerging economies have two choices – they can peg their currencies to the Dollar (like China) to protect their export markets and suffer inflation in their economies, or they can try to neutralize the Dollar inflows via higher interest rates, thus slowing their own expansions and, perhaps, impacting their employment levels.
Let’s look at what happens when a country, like China, pegs its currency to the dollar. Bernanke is correct when he claims that China wouldn’t have the inflation problem they have today if they allowed their currency to float. Here is the logic: Because the dollar is the world’s reserve currency, Chinese exporters receive dollars for their export products. Since they are not allowed to exchange those dollars for their local currency (renminbi) in an open market, they sell it to the People’s Bank of China at the pegged exchange rate.
The Chinese central bank has to print renminbi to purchase the dollars. So, the China nds up with dollars, but has printed an equal value amount of domestic currency. It is likely that, if the Chinese currency were allowed to freely float in the forex markets, inflation in China would subside. So would their exports and their GDP – and probably their employment levels.
Now let’s look at what has happened in countries with freely floating exchange rates, especially with regard to commodity prices. The first table show the changes in the price of commodities in the home currencies (i.e., the cost of commodities in the local currency), of 7 selected freely floating currencies for 2009 and 2010 as measured by the price of RJI, an ETN that mirrors the movement in the price of the Rogers Commodity Index.
The second table shows the Expense/Revenue ratios of the governments sponsoring those currencies as measured by data found in the IMF World Outlook database, October, 2010. Each table also shows the rank from best to worst in the change in commodity prices in the home currency in the first table, and in the Expense/Revenue ratio in the second table.
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