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Monetary expansion, the dollar, and commodity prices

By Sober Look

Economists continue to insist that there is no connection between Fed’s monetary expansion and increases in commodity prices, particularly agricultural products globally (discussed here). Here is a typical comment: 

If it is commonly believed that the FOMC can cause a worldwide food shortage then we are truly in a dark age of macro. The FOMC has no ability to raise the price of commodities relative to national income, and I can’t even imagine the rationale that monetary expansion could somehow increased prices internationally (that is, denominated in foreign currencies). The only way they could raise food prices in real terms is if they could spur increased food consumption domestically, which would be much more likely if they strengthened the dollar than if they weakened it. The FOMC can cause a lot of trouble, but this is just not on the list of problems they can cause, and certainly not via monetary expansion.

Unfortunately macroeconomic theory here diverges from market experience. Monetary expansion in the recent past corresponded with significant dollar weakness. The chart below shows the dollar weakening during both QE1 and QE2. “Twist” on the other hand did not involve monetary expansion and only focused on reducing the average duration of treasuries.

Source BNP Paribas

Dollar weakness to any commodity trader is a signal to buy – which is not necessarily linked to demand fundamentals. Those who don’t believe this should only take a look at the following chart comparing the dollar (DXY) with the CRB commodity index.

Source: Bloomberg

What’s important to point out here is that the commodity price movements have been much larger than the dollar movements. In fact on a percentage basis the CRB range in the graph above is almost double the dollar range. That means even for currencies that are not in any way tied to the dollar (although a number of emerging market currencies are), when the dollar weakens, commodity prices move higher even if denominated in these other currencies. Commodity price increases due to dollar weakness therefore propagate globally even in nations whose currencies are not linked to the dollar. This empirical relationship drives global commodity markets even if supply/demand fundamentals don’t warrant such adjustments. But when one faces tight and uncertain supply conditions to begin with (as we have now for agricultural commodities), dollar weakness will force an even larger commodities swings to the upside.

In 2011 the CIA was chastised for not being able to see the Arab Spring coming. Where did all that pro-democracy fervor come from all of a sudden? Why wasn’t the CIA able to see key signs of the movement earlier? The answer has less to do with zeal for democracy and more to do with not being able to buy food. As food prices spiked across the Arab world, so did the protests.

Source: Bloomberg

Certainly in the long run macroeconomic fundamentals should play out. But we don’t live in “the long run”. Global markets take seconds to reprice, usually far overshooting/distorting the “fundamentals”. And, as the Arab Spring showed, people don’t wait for these fundamentals to settle to their expected levels.




  1. Geoff says:

    There is little relationship between the size of the Fed’s balance sheet and inflation, or the US dollar. There is no money multiplier. Banks do not lend out reserves. This guy’s argument is bogus. If he’d said instead that QE forced down bond yields, which in turn caused a portfolio shift into commodities, I might have bought it.

    • David_Lazarus says:

      Portfolio shifting is the only credible evidence of the behaviour of commodity markets. Since the markets are anticipating more QE or similar what does that suggest for commodity markets in the coming months?

  2. Dave says:

    I think in the end perception is reality. That is a cardinal rule in trading, if the perception is that the expectation for future inflation is there then it would cause an increase in commodity prices. Look at gold, why has it continued to go up mostly because the perception of inflation even though core inflation has been very subdued.

    • David_Lazarus says:

      Personally I think that there are enough gold bugs out there who are seriously concerned about the debasing of the currency by repeated QE that quite frankly I agree with them. If all this extra money enters the economy it would be inflationary, so either it is locked up in banks or flows into a liquid market such as commodities.

      • Dave says:

        I agree, but isnt that perception vs. reality as well? Wasnt QE(1&2) supposed to be sterilized. Unless Im totally off-base on that.

        • David_Lazarus says:

          I am no gold bug but the problem of perception versus reality is really in the eye of the beholder. I have no idea how they would “sterilise” QE apart from unwinding all the transactions, but will banks ever be able to take the huge losses that would impose? Quite frankly I think that the price imposed on the public exceeds the benefits of the bank bailouts.