The subject of deflation, a serious concern for many between mid-1997 and mid-1999, has disappeared from most financial radar screens as surging crude oil prices and a global economic recovery have pushed an important change in sentiment.
One sector of the economy still affected by the syndrome of falling prices and increased production is agriculture. Higher grain prices were once as synonymous with inflation as higher energy prices. Floor traders in Chicago made a direct link: "When the beans fly, the bonds die!"
Well, it's been a long time since any bond trader glanced at grain prices for clues as to the direction of interest rates. This year has seen multidecade lows in both wheat and soybean prices just as it saw multidecade lows in heating oil prices. The grain markets have no equivalent of
to come to their rescue, and so long as the weather in major growing regions remains cooperative and technology streamlines production, prices should remain under pressure.
As a result, if we are to look for inflation -- and until the generation that grew up during the 1960s and 1970s retires, we will continue to look for inflation anywhere and everywhere -- we will need to look for evidence outside of base commodity prices. The exchange value of the dollar, the spread between nominal yields and inflation-adjusted yields, and even the risk premium for equities as opposed to bonds are likely replacement candidates.
The extent to which grain prices and bond yields have disconnected would amaze someone awaking from a coma begun in the late 1970s. While bond yields fell steadily from the aftermath of the 1987 crash to the start of the Persian Gulf War, wheat prices rose nearly 30%.
A collapse in wheat during 1990 coincided with an increase in bond yields, and a long rally in wheat from 1993 through 1996 saw both a sharp rise and fall in bond yields. The two markets mirrored one another from May 1996 through October 1998, but since have diverged.
Depends On What You Mean By 'Inflation'
While we chose wheat as a representative agricultural commodity, we could have chosen any number of others. Soybeans, sugar, cocoa and hogs all have witnessed long-term price deterioration. In December 1998, the same was the case with the petroleum complex and gold.
The point is simple in any case: With some notable short-term exceptions like that seen for wheat in 1996, commodity prices are in a long-term decline. This should be the case; if producers did not become more efficient, they would be facing substitution from new supplies. While the world's population has doubled over the past four decades, food production has never been higher, and real food costs have never been lower.
The implications of this trend for producers of primary commodities are unpleasant. The economic value of a bushel of wheat has not increased significantly over any length of time, nor is it likely to do so. The equipment, fertilizer, pesticides and genetic services a farmer buys have increased in both productivity and price relative to farm output. The result is a permanent deterioration of terms of trade for commodity producers, both individually and collectively.
Commodity producers strapped for revenue often are forced to flood new supply into the market. The Russians have been notably good at this, and have contributed to the price collapses this decade of such diverse commodities as aluminum, gold and crude oil. While commodity price collapses lower price indices, they are singular events, not longer-term increases in efficiency. E-commerce, on the other hand, is a long-term increase in efficiency, and should aid in reducing inflationary pressures for a long time to come.
Reductions in supply, be they of labor or of crude oil, do not appear to be causal of true inflation. The alleged tradeoff between inflation and unemployment contained in the
has not operated in periods of high inflation and high unemployment, such as the 1970s, nor in periods of low inflation and low unemployment, such as the 1990s.
Surging equity prices, a favorite worry of the
over the past few years, appear to reflect declining inflationary expectations, and certainly do not appear causal of future inflation. How else to explain how warmly the stock market has greeted the series of rate hikes during 1999?
One fine day, the price of wheat will rise again, and this will contribute to an increase in certain price indices. Unless you see confirming evidence of inflation from financial markets, hang on to your bonds. Inflation it's not.
Howard L. Simons is a professor of finance at the Illinois Institute of Technology, a trading consultant and the author of The Dynamic Option Selection System (John Wiley & Sons, 1999). At time of publication, Simons held no positions in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Simons appreciates your feedback at