Stephen King: Rising commodity prices need not signal the horrors of inflation

There is a whiff of monetary tightening in the air; markets seem to be expecting higher interest rates
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The Independent Online

Lightning, thunder, dials spinning around, electromagnetic surges, and a corpse lying on a table. Pretty scary the first time round, perhaps, but Frankenstein's monster gradually lost its power to send shivers down the spines of movie-goers. The franchise became over-exploited and, by the time it came to Young Frankenstein, Mel Brooks' wonderful spoof of the genre, we were able to laugh at the monster performing Puttin' on the Ritz and reading The Wall Street Journal.

Frankenstein's monster was easy to spot: big forehead, bolts through the neck and size 18 boots. And perhaps it was our ability to recognise him and become familiar with his ways that turned him slowly from scary monster to affable - if not loveable - monster. By now, you might be wondering what all this has to do with economics. Well, the answer is that economics has its own version of Frankenstein's monster. It might be more difficult to spot - no bolts, no big boots - but it still leaves people with a cold chill. I'm talking about inflation. Seen quite rightly as the policy maker's bogeyman over the past 40 years, we're still not sure how and when to deal with it. Is it lurking around the next corner, ready to jump out at us? And, if it does, what should we do? Run away, feeling scared? Clobber it with a dose of higher interest rates? Or just laugh in its face, knowing that the threat of yesteryear is no more?

I ask these questions because, in recent months, people have become more jittery about inflation. Why? I can think of a few obvious reasons. First and foremost, the world economy has rebounded quite nicely. Irrespective of the degree of spare capacity still floating around, this is seen in some quarters as a prelude to higher inflation.

Second, there is a whiff of monetary tightening in the air: on top of the "will they, won't they" debate about the Bank of England and its base rate intentions, markets now seem to be expecting higher interest rates in many different parts of the world, including the US.

Third - and this is what gets some people really excited - commodity prices have been heading upwards since the end of 2001. Higher oil prices are part of this story but, as the left-hand chart shows, non-oil commodity prices have also been heading up rather quickly. Combine this story with higher levels of global liquidity, and those with an active imagination could perhaps draw some parallels with the late 1960s. Back then, global growth began to slow, equities fell away after a huge bull market that spanned the 1950s and early 1960s and governments attempted to pump-prime anaemic economies. The dollar, the numero uno of global currencies, gradually came unstuck. Commodity prices surged and, the next thing we knew, the evil of inflation was upon us.

So, are we facing the same demons today? I think not. To explain why, it's worth focusing on commodity prices in a little bit more detail. In the late 1960s, commodity prices proved to be rather a useful lead indicator of inflation because they were telling us something about the overall strength of demand around the world relative to available supply. If commodity prices were going up, there was a good chance that other prices would also eventually go up. Companies had pricing power, unions had the power to demand wage increases, governments wanted to provide full employment guarantees and countries were generally more "closed" than they are today. Excess demand led to price increases for goods, services, labour and commodity prices. But because commodities were traded in liquid markets with complete price transparency, they became the best lead indicator of a more generalised rise in inflationary pressures.

In my view, a lot of these arguments simply do not apply today. Companies have lost pricing power, union muscle has slowly atrophied, and governments have handed the keys of monetary policy over to independent central bankers who care about inflation much more than they do about unemployment.

That's not all, though. Today, there may be specific reasons why a rise in commodity prices signals nothing about inflation at all. Instead, rising commodity prices may be telling us something about globalisation and capital mobility. I might go even further. Rising commodity prices could easily be consistent with falling inflation, not rising inflation.

This is, I suppose, a not very intuitive claim. Bear with me, though, because this is a story about changes in relative prices and wages that come about as the world economy becomes increasingly integrated. Let me start off by describing a totally non-integrated world. For want of better expressions, I'll choose "the west" and "the east". Each area has its own products, its own labour markets and each area has no contact with the other area - no trade, no capital flows. I'll also assume that "the west" is a lot more developed than "the east". This means the opportunity cost of producing those goods and services that might eventually become "globalised" is a lot higher in "the west" than in "the east". Put another way, the price of these goods and services and the labour cost of producing them are a lot higher in "the west" than in "the east"

Then assume three major changes. First, the geopolitical climate thaws and countries decide that talking to each other is not such a bad idea. Second, there is a revolution in capital mobility, the result of new treaties and new technologies. Third, communication costs between "the west" and "the east" collapse to a point where, in many industries, they become insignificant.

What happens? First, there is a gradual move towards a single labour market. No longer will it be so easy to distinguish between "east" and "west". Second, as capital flows from "west" to "east", to lower-cost centres of production, wages will tend to rise in "the east" but fall in "the west". With a single market for goods and services, though, this implies that the price of goods and services will tend to fall in "the west" from earlier times - labour costs are on average now lower than before for western producers - and, probably, will rise in "the east". Assuming, though, that "the west" was a lot richer than "the east" in the first place, the overall result will be to lower the average price of "newly-globalised" goods and services, thereby raising demand and stimulating additional production.

And this is where commodity prices come in. If, as a result of lower labour costs, the price of "globalised" goods and services falls and demand rises, it's likely that more of these goods and services will be produced than before. That puts upward pressure on demand for commodities - the raw materials needed to make these things in the first place - and, hence, upward pressure on commodity prices. In other words, rising commodity prices are merely a by-product of lower wage levels. This is a relative price game: commodity prices have risen only because labour costs have fallen.

It is the strength of growth in China (see right-hand chart) and other parts of "the east" that is giving rise to higher demand for commodities. But that strength is crucially dependent on "the east's" labour-cost advantage in our integrated global economy. Commodity prices may be rising but the overall costs of production are falling and, hence, there is no obvious inflationary threat. If you see Frankenstein's monster today, you're likely to conclude that it's only someone wearing a silly mask. Seeing an inflationary threat via higher commodity prices may be no different: behind the mask, the reality is one of cost erosion, not higher inflation.

Stephen King is managing director of economics at HSBC