Greenspan Isn't Looking for Inflation Clues in Commodity Prices

Alan Greenspan weighing in on commodities prices -- sounds like a conversational cocktail that would cure insomnia in a flash.

But in the second go-round of his monetary policy report to Congress, the Federal Reserve chairman dished -- in his inimitable style -- about what commodities prices mean for the inflation landscape as well as for the economic outlook. And the exchange gave investors some insight on just what Greenspan thinks of commodity prices as inflation indicators.

But the main thing these lagging prices illustrate is how the economy remains in the doldrums, despite the best efforts of the Federal Reserve to boost demand. Critics of the Fed, and there are many, believe it means the Fed isn't supplying enough liquidity to the economy. Others, such as The New York Times, surmise that the Fed's lost it's power to move the economy.

The reality is that the Fed has been supplying an alarming level of liquidity. But the fed funds rate is a blunt tool. Commodity prices are low because businesses have no incentive to spend -- something only time, and not the Fed, can heal.

Responding to a question from Sen. Robert Bennett (R., Utah), the Fed head said prices on steel, aluminum and copper are less valuable as inflation indicators and better suited to showing "what industrial activity is doing." Those measures have a greater use in judging new order demand, investment and world trade, Greenspan said. And, given that commodities prices have been on the downward path in the face of the Fed's cuts, it doesn't say great things about the economy.

Looking at commodities prices "is a useful gauge of industrial activity, but it also is a good gauge of producer prices," said Tony Crescenzi, chief bond market strategist at Miller Tabak. "The reason it's not as useful as an inflation gauge is because commodity prices only make up 10% of the inflation story. The bulk of the inflation story comes from wage demand."

The recent trends in such prices are valuable more as an indication of a decline in exports and imports, the strength in the dollar, and persistent profit issues that have hamstrung corporations, sapping their desire to spend on equipment.

Since the Fed began raising rates at the beginning of January, the price of aluminum is actually lower. It's dropped to 68.90 cents a pound to 66.20 cents. The price of copper cathodes is down to 73.02 cents from 87.77 cents. Using Bennett's reasoning, this would suggest liquidity has actually declined in the last seven months.

With the three-year annualized M3 money supply growth rising at its fastest rate in more than 15 years, and the Federal Reserve having cut interest rates by 2.75 percentage points since the outset of 2001, that's a tough claim to make. The simple reduction of the inflation question to a basket of commodities prices ignores business trends regarding debt levels, expectations for profits and consumer demand for goods that use these products.

Percentage Change of Commodity Prices Commodity prices are low because businesses have no incentive to spend

Source: Baseline

Copper wiring is ubiquitous in electrical equipment. But the demand for electrical equipment has dropped sharply in the last several months. In the third quarter of 2000, electrical machinery firms were utilizing 90% of their manufacturing capacity; by May it was down to 70%.

Aluminum demand has also dropped as companies have cut back on investment and the global economy has slowed. Industrial production has dropped nine months in a row, and industrial machinery firms are using less than 75% of their available capacity, compared with 83% in the third quarter of 2000. Steel prices, which dove in 1998 after the Asian emerging markets crisis, haven't recovered.

These examples come back to the notion that by attaching the Fed's actions to the trend in commodities prices, the market is still asking too much from the committee. The Fed was slow to act in late 2000, but they've since been quite aggressive. It's unrealistic to expect the Fed will be cutting rates much further (though another rate cut at the Aug. 21 meeting seems likely).

Greenspan has to be concerned that industrial metals prices continue to languish, because it is indeed an indication that demand isn't picking up yet for manufactured goods. Capital spending flourished in the 1990s, but really took off at the end of the decade, when it was arguably "Engine 1" propelling the economy forward. Without that, the economy's been sluggish, and remained that way.

Companies are aren't spending money for good reason: high debt loads, current earnings, and more importantly, the profit outlook is still gloomy. Fed rate cuts aren't going to change companies' view within six months, not after the 10-year capital-spending boom in the U.S.

In this era of increased disclosure from the Fed, it's always nice to know a little more about what Greenspan is thinking. But that can't help but make people continue to draw dreary conclusions.