Commodity Prices – Swings and Roundabouts

Commodity markets had gone off in their own direction but are now back on track to help out with the global economy

The global economy has suffered more downs than ups over the past few years but lower commodity prices will provide some long needed cheer.  Long after the onset of the global financial crisis, prices for everything from copper to vegetable oil continued to rise stoked by demand from places such as China.  Weaken global demand has finally taken affect and relief in on the way for consumers everywhere.  It is likely to provide a bigger boost than just a bit of extra cash.

A guide to the road ahead

Commodity markets often follow their own roadmap.  Demand for different materials can rise and fall depending on changes in technology or consumption patterns.  The rising wealth of China and India has pushed up prices for everything from gold to milk powder.  New fracking technology has lowered the price of oil while corn became more expensive due to its use in producing ethanol in the United States. 

Supply further complicates matters as rising demand for any commodity will prompt companies to increase output but this often takes time.  There is a lag of a year or so for farmers to shift from growing one crop to another and even longer for a new mine or source of oil to be developed.  The changing demand and the delayed response on the supply side means that twists and turns in the commodity markets are often accentuated.

Back on the map

Prices in the commodity markets had long been out of kilter with the slump in global demand but this seems to be over.  The price of oil, which has been making news recently, is indicative of this new trend.  Increased output in the US coupled with a tailing off of demand from energy-hungry China has resulted in a sharp turnaround in prices.  High prices for commodities such as oil often do not last as more money gets spend on both finding more oil as well as on increasing energy efficiency to lower money spent on oil.  Both of these factors act to stop the price of oil getting out of hand. 

Market correcting forces move in both directions and also work to prevent excessive falls in prices.  Investments in producing commodities are put on hold if prices drop back and low supply tempers a decline in prices.  Lower prices also mean that interest in using resource more efficiently tends to fade.  This is why commodity prices tend to fluctuate in big swings of boom and bust.  With the world economy have just endured a period of high prices, the commodity market seems to be swinging in the opposite direction.  Considering the big swings in commodity prices, this trend is not likely to be reversed any time soon. 

Heading in the right direction

The benefits of lower commodity prices extend beyond the obvious effects of cheaper prices at the petrol pump, on our gas and power bills, and when stocking up at the supermarket.  Less money will go to places such as Saudi Arabia and Russia, where high oil prices only add to the riches of already wealthy individuals, and consumers across the globe will instead have more money in their pockets.  As such, the global economy will benefit as this extra cash will likely to spent rather than piling up in the bank accounts of rich Saudis or Russians.

A further benefit of lower commodity prices is that cheaper commodities mean lower inflation and lower inflation allows more scope for looser monetary policy.  An uptick in inflation would be one excuse that central banks would use to raise interest rates.  But with inflation likely to be subdued (and deflation becoming more of a concern), interest rates are more likely to stay at their current low levels or hardly rise at all when interest rates are eventually raised.  The absence of inflation could even result in a long-needed rethink of what central banks should be doing in terms of monetary policy.  That may work out to be even be more valuable than a few extra notes in your pocket.

Interest Rates – Looking for the right temperature

The economic climate is changing but that may not necessarily mean that interest rates have to change too

Setting interest rates can be as frustrating as fiddling with the heating as the seasons change.  We can rely on the weather forecast as a guide to the outside conditions but it is harder to get a measure of whether the economy is running hot or cold.  This is particularly tricky at a time when some central banks are switching from policies to warm up the economy to measures for preventing the economy from overheating.  The poor economic outlook suggests that the current monetary policy measures may be here to stay despite calls for higher interest rates.

Neither too hot nor too cold

Interest rates are often raised or lowered to nudge the economy toward what is seen as an appropriate rate of growth.  Once the economy is humming along as it should (with inflation in check), interest rates are ideally set to a level that neither helps nor hinders economic growth.  This is the concept of neutral interest rates which should be higher for fast growing economies and lower for economies with weaker growth.  Not only are there differences between countries but the neutral interest rate for one particular country can change over time.

The neutral interest rates have been slipping downward for many countries as their prospects for growth deteriorate.  Many consumers as well as governments are focusing on paying back debt leaving less money to spend.  Companies are hoarding cash instead of investing which takes away another driver of growth.  With most developed countries suffering from the same problems, exports don’t offer much help either.  Even economic growth in China, which has been one of the few bright spots in the global economy, is likely to slow from a boil to a simmer as focus shifts from investment to consumption.

Turning up the heat

There are signs that the global economy is heating up in places.  The British economy is expected to expand by around 3.0% in 2014 while around 2.0% growth is forecast for the US economy.  Yet, the effects of this are not being felt by consumers due to stagnating wages and cuts to government spending.  Low inflation is a further indication that not all is well even these economic hot spots.  These mixed signals have prompted a cautious approach by the US Federal Reserve and the Bank of England who have kept interest rates at record lows close to zero.

The lingering hangover from the global financial crisis continues to hold back the economic recovery.  Consumers are less willing to take on debt after the disastrous results of the previous borrowing binge.  Any plans of investment are reigned amid worried about the prospects for the economy.  Proactive policies tend to go out the window as politics regresses to squabbling over limited government resources.   The likelihood for these factors to lower the neutral interest rates means that interest rates are unlikely to go up by much at all. 

Don’t touch that knob

Depending on the extent to which the neutral interest rates have fallen, it could even be argued that interest rates should stay close to zero until the medium term prospects improve.  There is no immediate reason for interest rates to be raised considering that the main concern of central banks, inflation, is not a concern.  Even looking forward, inflation is likely to remain subdued when factoring in falling commodity prices and weak wage growth.

Moreover, lending has not gotten out of hand except for in isolated sectors such as real estate in certain countries (such as the UK).  Other worries also include low rates of return pushing investors to chase after higher pay-outs by putting money into increasingly riskier investments.   Yet, these issues can be dealt with using targeted policies rather than relying solely on interest rates.  Higher interest rates are seen as helpful in that it will give central banks more capacity to respond in the case of another downturn.  But setting interest rates has less of an effect when the financial markets are awash with cash. 

Like a bickering couple arguing whether the heating is set too high or too low, expect the debate over the right level for interest rates to drag on.  Despite all this, it looks as if interest rates might be best left where they are for now.

Question – where next for Japan

An inquiry from a reader prompts Your Neighbourhood Economist to look into the prospects for Japan

There has been another knock at the door of Your Neighbourhood Economist, with a reader what I thought Japan should be doing in the short and medium term?  The question arrived just days before another big policy development in Japan with the central bank ramping up its monetary policy.  This is the latest attempt by policy makers in Japan to resurrect an economy that has been languishing for decades.  To get an idea of what Japan should be doing, we need to start with what went wrong and why Japan has not made much progress.

What is not going right?

Japan got itself into trouble in the 1980s with the spectacular collapse of a financial bubble from which it has never recovered.  Property prices have fallen almost every year for two decades while prices for consumer goods have been inching lower for almost as long.  Japan has repeatedly tried to use fiscal stimulus but higher government spending has been unable to mask deeper problems with the economy.  Along with numerous roads and bridges which are hardly used, the main result of these rescue attempts has been a ballooning amount of government debt which only adds to Japan’s woes.

Monetary policy has been adopted recently as the potential saviour in the fight against what has been deemed as the main problem – deflation.  Falling prices were seen as prompting consumers to hold off spending and preventing companies from investing.  With this in mind, the central bank in Japan announced plans to double the money supply in early 2013.  But the policy of pumping more money into the economy was based on the false logic that deflation was a problem rather than just the symptom of a weak economy.  Instead, it is likely the case that deflation persists because prices rises had gotten out of hand in the past and need to fall back to appropriate levels.

Fix-up job not working

The result of this monetary policy has been as Your Neighbourhood Economist might have expected with just a brief and temporary boost to inflation.  Prices for consumer goods cannot rise consistently if consumers themselves do not get a similar rise in pay.  Higher wages in Japan seem unlikely as a declining population hurts aggregate demand and Japanese firms invest more overseas than domestically.  Yet, rather than change tact, Japan’s central bank has opted for more of the same. 

This involves the Bank of Japan aiming for an even larger boost to the money supply in Japan with annual purchases of 80 trillion yen (US$720 billion or £450 billion) in government bonds.  The timing of the new policy comes as the Japanese economy is faltering under the added weight of a tax hike designed to fix the government’s finances.  Japan has gotten itself deeper and deeper into trouble and seems likely to be an example of what not to do in terms of fiscal and monetary policy.   

Where to from here

The best option left to the Japanese government is to reform the economy so as to increase competition and improve efficiency.  There is substantial domestic opposition to reforms even within the current government headed by Prime Minister Shinzo Abe who included reforms as one of his key policies.  An easy way to sidestep domestic politics would be to jump on-board to plans for the Trans-Pacific Partnership (TPP).  This is a free trade agreement with the United States, Australia, Mexico, Chile, and other countries around the Pacific Rim.

Left to themselves, Japan will probably continue to stagnated due to the stifling effects of its consensus style of politics which make it tough to come up with reforms that keep everyone happy.  As such, Japan has a history of positive change only coming when imposed from the outside and this free trade agreement looks likely to follow this trend.  Greater competition from foreigners will help lower costs of business and create impetus for freeing up businesses in Japan from a host of restricting rules.  Facing up to the outside world looks like the best way to inject life back into a Japanese economy that has been slowly decaying for years.