What's behind it and Who's ahead of It:
Inflation caused by Commodities and Central Banks' Action
Ana Nogueira
Financial Markets
With the situation regarding Russia’s invasion of Ukraine prolonging longer than expected, inflation has been rising incessantly and reaching record peaks when compared to the last few decades. In February 2022, inflation in the US reached a shocking 7.9% and, in March, it hit 7.5% in the Euro Zone, values that had not been seen since the beginning of the 80s in either of these economies.
When analysing this inflationary trend, one can attribute fault to the reopening of the economy, which has been slowly going back up to its previous levels of activity, and to Central Banks’ expansionary monetary policy, through low interest rates and asset purchase programmes. However, the former are factors that have been coming into play in the monetary picture for quite some time now. So, the main cause for this phenomenon lies in a strong surging in commodity prices, from fuels, to grains, to metals.
Between the beginning of this year and the end of March, Brent an Natural Gas grew around 40%, and US Wheat around 31%. In fact, commodity funds are becoming very attractive to investors, so much that throughout this last year energy funds worldwide have grown 25%, precious metals funds 12.6% and agriculture funds 9.8%. These funds attracted a net inflow of $7.9 billion this February, compared to January’s $5.3 billion, and the highest value since August 2020.
The surge in commodity prices has been fuelled, naturally, by Russia’s invasion of Ukraine, which has halted economic growth and weakened people’s trust in the economy, creating fear of scarcity among economic agents and leading people to take refuge in tangible assets. Another factor playing into this are bottleneck-related price pressures in the energy sector, considering there have been supply chain disruptions and other fundamental production issues, contributing to imbalances between supply and demand and further raising products’ prices.
Jerome Powell, Federal Reserve’s Chair, said in March 2022 that, every 10$ price increase per barrel of crude oil raises inflation by 0.2%. So why do commodity prices hold such a power in consumer prices?
Firstly, families directly pay higher prices for domestic energy, necessary for lighting, heating and proper function of all electronic items, abundant in the average household. In fact, energy constituted as of December 2021 about 7.3% of the US Consumer Price Index, the main measure of inflation, thus exerting a direct effect on the inflation rate. Along with that, as wheat’s price rises, family’s endure growing prices in the food sector. Energy and food being essential goods, these two particular factors greatly impact every family’s budget.
Furthermore, rises in energy prices cause ripples across all sectors in the economy, due to increases in the cost of inputs: as transportation is based mainly on fossil fuels, a growth in oil prices will rise distributors costs as well as prices on consumers’ end. On top of that, crude oil is a main ingredient for the production of plastic, which ends up additionally affecting prices of products which include plastic, one of the most common materials in the global economy. One should also consider that companies, as end consumers of energy, are affected as any sort of production that involves electricity will increase in cost.
Faced with consistently high inflation rates, well above their 2% threshold, Central Banks have already started to impose policy in order to tame what could become a dangerous, spiralling and difficult to control trend.
A narrative of tightening monetary policy is consensual across all Western countries. The Federal Reserve is expected to start increasing interest rates in April already and the markets anticipate for there to be seven rate hikes this year alone in the US, reaching between 1,75% and 2% by the end of 2022. The European Central Bank has announced that it would progressively slow down their Asset Purchase Program and end their Pandemic Emergency Purchase Programme – however, raises in interest rates in the Euro Zone may only be expected after ceasing of APP and at a gradual pace. The Bank of England proceeded as well with back-to-back interest rate increases, for the first time since 2004, and is expected to keep up with more consecutive raises.
Yet, these persistent raises in inflation rates are overlapping with a slow and fragile economic recovery that must be stimulated and with an economic shock caused by the war, which forces Central Banks to weigh in a lot of conflicting factors when deciding their policy. The need to sustain said recovery makes it more difficult to tighten monetary stimuli, with fears of denting growth. This hard-to-reach balance is causing some economies, such as Japan or Thailand, to be more prudent and maintain low interest rates, even with inflation spiking.
This hesitation was seen not only in the former countries’ Central Banks, but also in the ECB and, to some extent, in the Federal Reserve. Specialists argue that the ECB lagged behind in taking measures to tighten monetary policy, having for too long based themselves on the assumption that the increases in prices were transitory. This belief enabled a light, slow approach to the matter, which entailed a heavy price to pay – this attitude will require over-compensation in the future, with excessive tightening which will aggressively rock the global economy and markets, rather than allowing for a smooth transition. The Fed followed a similar path of inaction, having yet to cease its large-scale asset purchases.
Now, circling back to the beginning of the topic, can one establish a relation between monetary policy shocks and commodity prices? In other words, can the restrictive measures that are being taken by Central Banks not only tackle inflation but also address the problem’s root cause, driving down commodity prices?
This hypothesis has already been studied by a lot of authors. In “Determinants of Agricultural and Mineral Commodity Prices”, by Frankel and Rose (2009), it was explained that restrictive monetary police, by raising real interest rates, increases the cost of holding inventories, lowers demand for commodities by slowing down production levels and increases supply by incentivizing countries to pump oil for higher return rates instead of keeping it under the ground: all of these factors combined drive down commodity prices.
Considering the changes in monetary policy are still very recent and have yet to reach its full form, no real effects of these measures have been detected thus far. However, based on the information provided by the previous study, one may expect this gradual change in policy to further repress inflation – or at least contribute to tame it, as we still deal with unavoidable external factors – by reducing commodity prices, tackling one of the main root problems.
Ana Nogueira
Financial Markets
With the situation regarding Russia’s invasion of Ukraine prolonging longer than expected, inflation has been rising incessantly and reaching record peaks when compared to the last few decades. In February 2022, inflation in the US reached a shocking 7.9% and, in March, it hit 7.5% in the Euro Zone, values that had not been seen since the beginning of the 80s in either of these economies.
When analysing this inflationary trend, one can attribute fault to the reopening of the economy, which has been slowly going back up to its previous levels of activity, and to Central Banks’ expansionary monetary policy, through low interest rates and asset purchase programmes. However, the former are factors that have been coming into play in the monetary picture for quite some time now. So, the main cause for this phenomenon lies in a strong surging in commodity prices, from fuels, to grains, to metals.
Between the beginning of this year and the end of March, Brent an Natural Gas grew around 40%, and US Wheat around 31%. In fact, commodity funds are becoming very attractive to investors, so much that throughout this last year energy funds worldwide have grown 25%, precious metals funds 12.6% and agriculture funds 9.8%. These funds attracted a net inflow of $7.9 billion this February, compared to January’s $5.3 billion, and the highest value since August 2020.
The surge in commodity prices has been fuelled, naturally, by Russia’s invasion of Ukraine, which has halted economic growth and weakened people’s trust in the economy, creating fear of scarcity among economic agents and leading people to take refuge in tangible assets. Another factor playing into this are bottleneck-related price pressures in the energy sector, considering there have been supply chain disruptions and other fundamental production issues, contributing to imbalances between supply and demand and further raising products’ prices.
Jerome Powell, Federal Reserve’s Chair, said in March 2022 that, every 10$ price increase per barrel of crude oil raises inflation by 0.2%. So why do commodity prices hold such a power in consumer prices?
Faced with consistently high inflation rates, well above their 2% threshold, Central Banks have already started to impose policy in order to tame what could become a dangerous, spiralling and difficult to control trend.
A narrative of tightening monetary policy is consensual across all Western countries. The Federal Reserve is expected to start increasing interest rates in April already and the markets anticipate for there to be seven rate hikes this year alone in the US, reaching between 1,75% and 2% by the end of 2022. The European Central Bank has announced that it would progressively slow down their Asset Purchase Program and end their Pandemic Emergency Purchase Programme – however, raises in interest rates in the Euro Zone may only be expected after ceasing of APP and at a gradual pace. The Bank of England proceeded as well with back-to-back interest rate increases, for the first time since 2004, and is expected to keep up with more consecutive raises.
Yet, these persistent raises in inflation rates are overlapping with a slow and fragile economic recovery that must be stimulated and with an economic shock caused by the war, which forces Central Banks to weigh in a lot of conflicting factors when deciding their policy. The need to sustain said recovery makes it more difficult to tighten monetary stimuli, with fears of denting growth. This hard-to-reach balance is causing some economies, such as Japan or Thailand, to be more prudent and maintain low interest rates, even with inflation spiking.
This hesitation was seen not only in the former countries’ Central Banks, but also in the ECB and, to some extent, in the Federal Reserve. Specialists argue that the ECB lagged behind in taking measures to tighten monetary policy, having for too long based themselves on the assumption that the increases in prices were transitory. This belief enabled a light, slow approach to the matter, which entailed a heavy price to pay – this attitude will require over-compensation in the future, with excessive tightening which will aggressively rock the global economy and markets, rather than allowing for a smooth transition. The Fed followed a similar path of inaction, having yet to cease its large-scale asset purchases.
Firstly, families directly pay higher prices for domestic energy, necessary for lighting, heating and proper function of all electronic items, abundant in the average household. In fact, energy constituted as of December 2021 about 7.3% of the US Consumer Price Index, the main measure of inflation, thus exerting a direct effect on the inflation rate. Along with that, as wheat’s price rises, family’s endure growing prices in the food sector. Energy and food being essential goods, these two particular factors greatly impact every family’s budget.
Furthermore, rises in energy prices cause ripples across all sectors in the economy, due to increases in the cost of inputs: as transportation is based mainly on fossil fuels, a growth in oil prices will rise distributors costs as well as prices on consumers’ end. On top of that, crude oil is a main ingredient for the production of plastic, which ends up additionally affecting prices of products which include plastic, one of the most common materials in the global economy. One should also consider that companies, as end consumers of energy, are affected as any sort of production that involves electricity will increase in cost.
Now, circling back to the beginning of the topic, can one establish a relation between monetary policy shocks and commodity prices? In other words, can the restrictive measures that are being taken by Central Banks not only tackle inflation but also address the problem’s root cause, driving down commodity prices?
This hypothesis has already been studied by a lot of authors. In “Determinants of Agricultural and Mineral Commodity Prices”, by Frankel and Rose (2009), it was explained that restrictive monetary police, by raising real interest rates, increases the cost of holding inventories, lowers demand for commodities by slowing down production levels and increases supply by incentivizing countries to pump oil for higher return rates instead of keeping it under the ground: all of these factors combined drive down commodity prices.
Considering the changes in monetary policy are still very recent and have yet to reach its full form, no real effects of these measures have been detected thus far. However, based on the information provided by the previous study, one may expect this gradual change in policy to further repress inflation – or at least contribute to tame it, as we still deal with unavoidable external factors – by reducing commodity prices, tackling one of the main root problems.