The inflationary impact of rising commodity prices is overstated, but…and that’s a big but…it doesn’t mean rising commodities are necessarily good or should be ignored by policymakers. The various Federal Reserve banks are out in full force in recent weeks in an effort to talk down the impact of rising commodity prices. Although they’ve denied that QE2 is leading directly to higher commodity prices (which is total nonsense according to the BOJ) it’s clear that the Fed is worried about the price increases enough to feel the need to defend itself.
The latest report is from the Chicago Fed. In what is actually a very good paper, they discuss the impact of rising commodity prices. They state:
“The recent run-ups in oil and other commodity prices and their implications for inflation and monetary policy have grabbed the attention of many commentators in the media. Clearly, higher prices of food and energy end up in the broadest measures of consumer price inflation, such as the Consumer Price Index. Since the mid-1980s, however, sharp increases and decreases in commodity prices have had little, if any, impact on core inflation, the measure that excludes food and energy prices.”
They go on to show that rising commodity prices have tended not to correlate with high future inflation. I tend to agree with their analysis. As I have said before, with sagging labor markets and stagnant wage growth it is more likely that higher commodity costs are squeezing household balance sheets rather than expanding household balance sheets being the cause of the rise in prices. I have argued that this is likely to lead to slower economic growth and gauging from the latest round of Q1 GDP cuts that’s looking like the case. The Chicago Fed’s conclusion is most interesting:
“The modest dependence of policy on energy and other commodity prices implied by our analysis is not surprising. The shares of firm costs accounted for by energy and commodities are not large and, in fact, have fallen over time. Moreover, at least in the case of oil, price increases tend to slow the economy even without any policy rate increases. Of course, if commodity and energy prices were to lead to a general expectation of a broader increase in inflation, more substantial policy rate increases would be justified. But assuming there is a generally high degree of central-bank credibility, there is no reason for such expectations to develop—in fact, in the post-Volcker period, there have been no signs that they typically do.” (emphasis mine)
This is an important statement. QE2 is not necessarily leading to higher inflation via commodity prices, but it is directly putting the squeeze on household balance sheets and likely leading to a slower economy via higher commodity prices. One has to wonder then, what in the world are we doing with this experimental monetary policy if there is a risk that it is contributing to a slowing economy? While it is correct that higher commodity prices are unlikely to lead to high inflation it is incredibly misguided to shrug off these higher prices as immaterial. And if they are in fact leading to slower economic growth then the Fed needs to very seriously reconsider their future course of action.
The full paper is attached for those interested: