commodities and inflation protection

It’s clear from the commodity price increases experienced over the past couple years (see this post) and anecdotal evidence -- but not official government numbers -- that inflation has returned and that price increases will be making their way through the economy. Several consumer staples companies have already raised prices 5-7% (P&G, Kimberly-Clark, and Fruit of the Loom, for example). This is just the beginning.

Often, money moves into commodities as an inflation hedge, but do commodities actually protect one's purchasing power after the onset of rising consumer prices? Based on the last time we saw this in the U.S., the answer is "mostly, no". Commodity prices, not surprisingly, tend to lead increases in actual inflation. But once inflation emerges, their ability to purchasing power protection diminishes. Thus, commodity ‘investors’ (aka speculators) who get in near the end of the pricing uptrend do not tend to fare as well.

The above charts illustrate this phenomenon over the same period I discussed in the last two posts, 1964 through 1988. They show commodity prices (Commodity Research Bureau spot price index) rising prior to a major jump in CPI inflation, with the bulk of the price spike clustered into just a couple of years (up 22.1% in 1972 and 59.8% in 1973), while actual annual inflation was just around 4.0%. From 1964 through 1973, average annual inflation was just 2.5% while commodities rose 8.4% per annum. After 1973 and through year-end 1988, annual inflation averaged 7.1% while commodity prices rose just 1.9%. Today’s commodities investors might be disappointed in their future returns while consumers may similarly be displeased with future price increases.

I do not want to be fatalistic and state unequivocally that inflation is inevitable, but I am not optimistic that it can be avoided at this point. The longer commodity prices remain high, the more they lead to higher structural costs for the economy as a whole. Once companies raise prices, they do not tend to lower them. Likewise with wages.

The final chart illustrates commodity prices versus actual inflation since 2000. To me, this looks similar to the period from 1964 through 1974, when commodity prices rose ahead of actual inflation in the face of inflationary government policies (namely, deficit spending). We see similar policies in place today, coupled with unprecedented monetary intervention that isn’t likely to abate anytime soon, especially in the face of a still-stagnant economy. And our national balance sheet is in worse shape. Are the mistakes that led to stagflation in the 1970s being repeated? Unfortunately, it appears so.