Hamish McRae: Pop goes the commodities bubble – probably. And what a relief that will be
Sunday 08 May 2011
Suddenly – just this last week – it looks as though the commodity-price bubble may have popped.
If that is right, it will be a huge relief for all of us. Having such high commodity prices, including oil, at such an early stage of the recovery was one of the real dangers ahead. Since the topping out of prices seems at least partly to be associated with somewhat slower growth in the main emerging economies, it may also herald a period of better-balanced growth worldwide.
It is usually wrong to attribute sharp price movements of anything to a single cause and there seem to have been at least two, maybe three, things that have been underpinning this surge in prices. But at the top of the list must come the strong demand from the large emerging economies, the so-called E7. If you feel wearied by the string of letters and numbers – the G7 and G20, the Brics and so on – that keep being cited, the E7 is simply the largest economies that are not part of the old developed country clubs: it consists of China, India, Brazil, Russia, Indonesia, Mexico and Turkey.
As you can see from the main graph, growth in industrial production in those countries has closely tracked trends in commodity prices over several years. We get commodity prices more quickly than we get figures for industrial production, and this would suggest that some sort of pause is taking place in the emerging world. That would fit what seems to be happening in China at any rate. Even slightly slower growth in China would mean a material lessening of pressure on commodity demand, and a more widespread slowing elsewhere would completely change the picture. Demand varies from commodity to commodity, but taken as a whole, the E7 accounts for just about all the additional demand for most commodities and for oil. The main exception is some rare earths that are used in products such as hybrid cars, which are made mostly in Japan.
The other explanation for the fall in commodity prices is the prospective end to the Federal Reserve's second bout of quantitative easing. Commenting on this, Simon Ward, an economist at Henderson, notes that the Fed has already made changes to its QE programme, requiring the US Treasury to hold more cash on its account with the Fed. The effect is that it is no longer flooding the world with cash to quite the same extent as before. If you create great wodges of dollars they have to go somewhere, and one of the places they seem to have gone has been into commodities. Result: the Fed may have unwittingly exacerbated the commodity price boom.
There may be a further twist. Cheap money may also have led to more speculation in commodities, the third possible reason for the boom, and if that is right, the Fed and the other central banks are doubly responsible.
Realistically, demand from the E7 is probably more important than central bank action, but any easing of commodity and energy prices is most welcome and not just to the Fed. It is particularly welcome in Britain, where inflation is way above target, driven partly by the relative weakness of sterling but also by energy and import prices. The latest index on producer prices, out last Friday, was particularly worrying because producer prices inevitably feed into consumer prices after a few months, and consumer prices are double the target level.
As you can see from the right-hand graph, holding down inflation depends on the price of goods remaining subdued, for it is harder to obtain the same increases in productivity in services as it is in manufacturing, and accordingly hold down service-industry prices. (Incidentally, the main reason government services have had such a dreadful productivity performance – actually going backwards in many areas – may have been the excessive funds being thrown at them by the previous government. But to be fair, government is a service industry and all such industries struggle to lift productivity.)
To get to the 2 per cent target you have to have goods inflation close to zero. Note how the twin peaks of goods inflation fit with the peaks in commodity prices on the second graph. If the world can operate with reasonably high but stable commodity prices then it has a decent chance of a global growth phase, in both developed and emerging countries, being sustained for several years.
That is the prize. The world has to learn to grow without putting too heavy a burden on its natural resources. In previous cycles, or at least until the last expansion, most of the burden on the planet's resources came from the developed world. Now that is no longer the case. We in the developed world have to contain our own demands in order to make room for growth from the emerging world. To say that is not to strike some high moral tone. It is simply a reality: if the developed world does not find ways to reduce energy and raw material demand the market will do it for us. That is what is happening in, for example, the oil price at the moment. And even if we are collectively successful at conservation, the pressures from the rest of the world will continue to support the price of natural resources, particularly those where there is a finite supply, such as oil.
That puts both the recent bubble in commodity prices (and I think it has been a bit of a bubble) and this week's price falls into perspective. In an ideal world we need high but stable commodity prices: high because we need to keep the pressure on to conserve as much as possible, but stable so that growth is not unseated by price shocks. We have instead had a roller-coaster, with a huge surge at the top of the last global boom, which is to be expected, but another mini-surge now, which was more surprising – at least until you factor in the combination of demand from the emerging world and perhaps also the actions of the Fed and other central banks. If that mini-surge really is over that is good news, but do not expect a plunge in prices. In any case, we should be grateful that one serious worry over the still-fragile developed world expansion is just a little less serious than it was a week ago.
Note to Lib Dems: Hacking back our deficit is absolutely the European way
It is usually wrong to try to read economic significance from political results, but there is perhaps one point to be made on the UK's fiscal consolidation plan post those polls. It is that it is not only in the self-interest of the Lib-Dem part of the coalition that the fiscal plan should be successful and it therefore, three or four years down the line, can share in a government that has got finances back under control. It is that in doing so it is fitting in very closely to European good practice. European nations are fixing their deficits, while, so far at least, neither the US nor Japan has been able to do so.
True, Greece, Ireland and Portugal have been forced to do so by a combination of market and eurozone pressure. But the stronger nations are cutting back hard as well. Take France. On Thursday, Christine Lagarde, the Finance Minister, said the government was committed to reducing the deficit-to-GDP ratio from 7 per cent last year to 6 per cent in 2011, 4.6 per cent in 2012 and 3 per cent in 2013. Since the deficit last year was smaller than projected, France might even cut faster than this. Germany, too, is cutting its deficit faster than expected. According to an unnamed official, on Friday, this year's total public deficit is likely to be less than the 2.5 per cent of GDP forecast by the government in April and could be closer to 2 per cent. As for Italy, despite cutting its growth forecast for next year, it is sticking to its forecast budget deficit of 3.9 per cent of GDP this year and 2.7 per cent in 2012.
So the big three European economies are all aiming to be back to the Maastricht debt ceiling by 2013 at the latest – a year, maybe two, earlier than us. Seen in this context, Lib-Dem support for the cuts is absolutely standard European practice. Don't shout it in Sheffield but were they really true to their European inclinations they would be urging the Tory side of the coalition to cut the deficit even faster.
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