This Makes Sense: Tracking Commodities Response to Bad Monetary Policy

Prices for food and energy commodities have risen in synch with the falling value of the US dollar. Since the recent rapid cuts in interest rates by the US Federal Reserve Bank, the commodities market has gone wild with speculators. Worldwide commodities havoc caused by the weak US dollar is one more indication to politicians who meddle in monetary policy that trying to get something for nothing rarely works out well.

Eight months into the Fed's most recent rate-cutting spree, the evidence is overwhelming that it has been a major policy mistake. Aggressive rate cutting – taking the fed funds rate to 2.25% from 5.25% last September – has had little effect on the banking crisis it was supposed to ease.

...the Fed's decision to open the general monetary spigots has inspired a global commodity boom unlike any since the 1970s. Oil has climbed to nearly $119 a barrel today from $70 in late August, a 70% increase. Farm and other commodities have seen a similar surge, with corresponding increases in food prices leading to shortages and riots in Egypt and other places, and to rice hoarding even in Southern California.

...Like oil, world trading in most commodities is denominated in dollars. When the dollar declines, especially as fast as it has since September, commodity prices surge and speculators gamble on even further declines. As the nearby chart shows, since 2003 the dollar price of oil has climbed far more rapidly than has the euro price – 273% in dollars, compared to 146% in euros. Note in particular the oil spike in dollars since the second half of last year. This reflects the European Central Bank's sounder monetary management. And it means that had the dollar merely retained the same purchasing power as the euro, today's price of oil would be below $70 a barrel.

The practical impact has been to send energy and food prices soaring. This is a direct tax on both the world's poor and America's middle class. Just when the U.S. economy needs a resilient consumer given the fall in housing prices, these price increases have eviscerated consumer pocketbooks. In its attempt to help Wall Street and the financial system, Fed policy is punishing average Americans. The public is frustrated and angry with these price increases, and it has a right to be. Inflation is the thief of the thrifty middle class.

The Fed's weak dollar policy has also done great harm to overall financial confidence, which is essential to any growth revival. A main source of the credit crisis is a lack of trust. Investors stop taking risks, bankers stop lending, and everyone flees to the safety of Treasurys or cash. But how can the Fed expect people to calm down and begin taking risks when it is clearly debasing the currency? Monetary easing itself also becomes less effective, because without confidence more liquidity is merely "pushing on a string," in the famous phrase. __WSJ

The logic makes sense, and economists such as Larry Kudlow have been sounding the warning for some time now.

What would be the short-term cost of letting interest rates rise, and firming up the dollar? If the rates rise too rapidly, a severe recession could occur. A more gradual raising of rates would in the short term depress some economic activity. It is a political risk in the front of the minds of incumbents.

Someone needs to have the courage to take the strong medicine. Otherwise the current slipping into a chaotic commodities environment will sooner or later exact a much higher price.


Of course, commodities could be linked to the Euro instead of the US dollar. The problems with that approach lie with the much weaker long term demographic prospects for Europe as a whole, and the dependency of Europe on the US for its defense. Europe's economy has been largely spared the huge expense of maintaining world trade routes, and all that that implies.

US defense costs in pursuing the anti-jihadist actions in Afghanistan, Iran, the Horn of Africa, and numerous other parts of the globe are a significant expenditure, although not so much when looked at as a proportion of the GDP historically. At this pivotal time in history, the US has no choice but to maintain a large combat readiness to act as a counter-weight to the largely centrifugal forces of tribalism, neo-nationalism, and general third world nihilism so well described by Robert Kaplan.

The developed world is at the brink of a transition from one type of economy and philosophy to one that will be qualitatively different. Only one world power has the ability to provide stability, to allow the transition to take place. If that world power allows its very substance to erode through bad economic policy, it is the entire world that will pay the price.