Commodity prices have risen sharply in recent months, leading some to worry about inflation. However, this document provides three reasons why inflation anxiety may be misplaced: 1) Higher commodity prices are primarily due to increased global demand from countries like China and India, as well as speculative factors related to low interest rates, rather than monetary policy. 2) The backdrop is very different from the 1970s, when high inflation became embedded - unions are less powerful and oil shocks no longer trigger wage increases. 3) Inflation expectations remain anchored and slack remains in the economy, so inflation pressures are unlikely in the foreseeable future despite recent commodity price rises, which are partly speculative and transitory.

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Inflation Anxiety – Misplaced?
February 14 – 18, 2011
Commodity prices have moved sharply higher over the last several months, leading to increased worries
that the Fed is “behind the curve,” “debasing the currency,” or “monetizing the debt.” Such fears are based
on a poor understanding of the inflation process and how the Fed conducts monetary policy.
No doubt, prices of raw materials have risen. There are some basic reasons for this. One is the global
growth story. Increased demand from China, India, and others will put upward pressure on commodity
prices. Commodity prices are also a function of interest rates. Low interest rates cause a relative increase
in the value of stuff in the ground (due to lower discounting), creating less incentive for extraction, and
reducing the cost of holding inventories. Perhaps more importantly, there is a speculative element, which
was plainly evident in 2007 (and that speculative element is also a function of low interest rates).

2. A drought in Russia has put upward pressure on grain prices. The demand for food is relatively inelastic
(that is, price changes generally don’t have a big impact on the quantity demanded). Hence, it doesn’t take
much of a change in supply to have a big impact on food prices. China is also experiencing a drought,
which is likely to keep wheat prices elevated. However, high prices tend to encourage higher crop yields
down the line.
Many are old enough to remember the Great Inflation of the 1970s and early 1980s. Having lived through
that, it’s natural to be concerned that we may be about to repeat that experience. However, the backdrop
is a lot different now. In the early 1970s, one out of four private sector workers were in a union. Many of
those unions had cost-of-living adjustments (COLA) in their wage contracts. So, an oil price shock lifted
the CPI, union wages rose, followed by non-union wage increases, and inflation quickly became embedded
in the labor market. It took an induced recession by the Volcker Fed to wring inflation expectations back
down. In contrast, union membership in the private sector was less than 7% in 2011 (a greater percentage
of government workers are union, but they don’t have much bargaining power on wages). We’ve had a
number of oil price increases over the last 10 years and none has lead to higher wage demands or an
increase in the underlying inflation trend. Instead, higher energy prices tend to dampen growth.

3. Consumer price inflation is driven by inflation expectations, which remain well-anchored, and by the
amount of slack in the economy. While the economic outlook has improved, the unemployment rate is
expected to remain elevated for a number of years. Capacity utilization is rising, but remains relatively low
by historical standards. Slack in production implies that we’re likely to see few bottleneck inflation
pressures in the foreseeable future. For manufacturers, commodity price inflation is real. However, firms
still generally have a relatively limited ability to pass higher costs along.
What role does the dollar play in higher commodity prices? Not much. Commodity prices are higher in all
currencies, not just the dollar, and the dollar isn’t all that weak against the major currencies. Also, it does
not matter that oil and other commodities are denominated in dollars.
What role has U.S. monetary policy played in commodity prices? Some, but not as much as you might
think. In general, easier monetary policy implies higher commodity prices (see the interest rate
explanation cited earlier). More importantly, think about how the Fed conducts monetary policy. Raising
or lowering interest rates is meant to influence the rate of loan growth, helping to ease or tighten
pressures on resources (capital and labor). Does anybody think that private-sector loan growth is
currently excessive? That doesn’t appear to be the case in the U.S., but could be an issue more globally.
However, that’s an issue for foreign central banks. Commodity price pressures are largely a transitory
problem (food, especially), partly fueled by speculation. This isn’t the 1970s.