Commodities Can't Measure Inflation

Productivity

The groupings in this chart tell a story in and of themselves. Renewable resources, whether they are grains, renewable industrials such as wool, cotton or rubber and livestock, all have fallen steadily over time. Rubber, addressed here in August 2000, is particularly striking, inasmuch as the world's tire population has grown considerably since 1946, and modern radial tires require natural rubber. Even recyclable industrial metals such as steel scrap and copper have declined steadily over time. Other industrial metals, such as zinc, tin and aluminum, essentially have kept pace with inflation.

That leaves us with precious metals and energy. Both natural gas and crude oil are somewhat misleading because they were under price controls or cartel controls for much of the available history. Even gold, the most inflation-sensitive commodity, was under price controls until the mid-1970s. And silver's positive coefficient is an artifact of the Hunt brothers' 1979-1980 escapades, in which they created a silver bubble that soon popped.

Let's stipulate that conventional crude oil and natural gas, crude oil in particular, are rising in price faster than inflation. They are not renewable resources and they are not recyclable in any economic sense. Because we extract the cheapest resources first, we should expect to encounter higher marginal extraction costs and diminished returns on investment; this is the "peak oil" argument. But even here the laws of economics have not been repealed: The energy cost of producing a constant dollar of GDP has fallen steadily for three decades and shows no signs of slowing anytime soon. The current surge in prices provides increased incentives for energy productivity, so we should expect the decline in the chart to accelerate in the years ahead.

Productivity mandates declining real commodity prices over time. The chart below illustrates that this has proven true. Commodities are not financial assets, they are factor inputs to production. If their real price does not decline, they will lose market share to substitution and conservation. This is very different from, say, a stock, which can become more attractive at a higher price.

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Source: Energy Information Administration

Great Expectations

One of the great mysteries of economics is why analysts totally familiar with the historic volatility of the past are so willing to project smooth paths for the future. Markets do the same; let's take an expectation variable such as the Treasury inflation-protected securities market's implied rate of inflation for the next 10 years and map it against the Dow Jones-AIG index.

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Source: Bloomberg

This expectation has matched the commodity index only for a brief time, between the stock market low of October 2002 and the bond market's acceptance of ever-tighter monetary policy in April 2005. Economic growth and monetary policy must coincide for expected inflation and commodity prices to correlate. At present, the two have diverged until the weight of the fed funds rate increases.

Inflation

I am beginning to conclude that we are at a Potter Stewart moment, which takes its name from the late Supreme Court justice who famously knew obscenity when he saw it. We all believe that we know inflation when we see it, and suffice to say very few of us feel our individual costs of living are measured well by the government's price indices.

Inflation as a concept includes the length of each of our planning horizons and our perceived personal financial risks as well as the backward-looking measures employed in the price indices. It is a forward-looking market, a change in behavior. No thermometer can measure it, certainly not that of the commodities markets.