How’s That Commodities-Based Inflation Forecast Looking These Days?

Funny how you don’t hear much these days about inflation worries based on rising commodities prices. Mysterious? Well, not really. Commodities prices are down recently–sharply. The cash price of crude oil (West Texas Intermediate) is under $80 a barrel, as I write—off from nearly $115 in late-May. A number of other key commodities have tumbled recently as well. Nothing like a big round of selling to change perceptions. That’s the point–commodities prices bounce around a lot, and so we shoud be cautious when it comes to making big decisions based on the price du jour.

A few months ago, however, warning about inflation risk based on elevated prices of raw materials was all the rage. But as I noted at the time, commodities were less than a reliable guide to future inflation (see my post here too). Indeed, one of the prized aspects of commodities prices—high volatility—among traders is also a reason why the asset class is suspect as a variable for estimating the inflation trend. That didn’t stop some pundits from screaming for higher interest rates to fend off the perceived surge in inflation. Commodities prices were rising and that alone was enough to pull the trigger. Never mind the wider economic context, or the lack of support in core inflation measures.
Several months later, it’s clear that raising interest rates in, say, May would have been exactly the wrong thing to do. The economy is weaker and commodities prices are lower. One might wonder if official readings of inflation will complete the circle in the months ahead. The latest reading on headline consumer price inflation reveals a seasonally adjusted annual rate of 3.4% through June. That’s a jump from recent history, although core inflation (which strips out food and energy prices) still looks relatively contained. The fact that the two series weren’t in agreement recently is another reason to wonder if commodities prices were giving us reliable information about the future.
Critics still rail against the concept of core inflation, but it’s saved us from making rash decisions more than once. In mid-2008, on the eve of the financial crisis and (as it turned out) in the early months of the Great Recession, commodities prices were rising and so headline CPI was too, as the chart below shows (the blue line is headline CPI). But core inflation (red line) remained fairly stable. Core proved to be the more reliable measure of inflation, as indicated by the collapse of headline CPI’s annual rate in late-2008 and early 2009.
More recently, headline CPI zipped higher. But this alone wasn’t fate, as suggested by the lack of confirmation in core CPI, which remained subdued. All the more reason to think that headline CPI was a head fake once more. The recent downturn in economic expectations all but confirms the suspicion.
Ditto for the market’s outlook on inflation these days. The yield spread for the 10-year Treasury less its inflation-indexed counterpart is around 2.2% at the moment. That’s down sharply from roughly 2.6% in the spring and more or less unchanged from levels in late-2010.
Meanwhile, there’s chatter that the European Central Bank, which had recently warned of rate hikes to fend off perceptions of rising inflation, is having second thoughts. As Kantoos Economics explains,

Another commodity boom “tricked” the ECB into raising rates at the worst possible time, even though there were no signs of a pass-through of the currently higher headline inflation to core inflation, and thus, to medium term headline inflation. Now, this step will probably be reversed quickly, too. Why? Because even Germany might be heading for a recession.

Lest anyone think that we ignore commodity prices as a general rule, well, let’s nip that in the bud right here. Commodities can’t be ignored, nor should they be. But neither can we look at prices in a vacuum. There was too much of that earlier in the year, when commodities were soaring. But they were soaring in the wake of a massive financial crisis and a sluggish recovery. Yes, gold continues to march higher, but that’s less about inflation worries vs. solvency fears.
In any case, no one’s calling for higher rates based on commodities prices. That’s sure to change when the next rally ensues. Maybe they’ll be right the next time, but maybe not. Context is still king when analyzing the macro climate.