The 411 on Commodities, Inflation, and Monetary Policy

Commodities have taken center stage, and why shouldn’t they? They’ve been on a roll as of late, with prices rising through the roof!

Just go to your local gas station. With crude oil prices slowly inching up to $90 a barrel, gas prices have risen, and now I can’t hit the nightly drag races with Big Pippin and Huck (yes, it’s Huck’s dirty little secret – she loves racing!). Also, if you were paying attention last year, then you’d know that gold also rocketed up the charts.

You might be thinking, “Okay, commodities are rising, so this should be good for the comdolls, right?”

That is true, my young padawan. But you shouldn’t just think of Happy Pip and her comdolls when you hear commodities. You should also pay attention to how commodity prices affect inflation. As we all know from those fabulous lessons at the forex-wonder School of Pipsology, inflation plays a crucial role in how central banks make decisions on monetary policy.

Before I get to that, lemme first discuss how rising commodities affect countries in different ways. Some will have to deal with rising consumer prices more than others. Now, I hate to be the bearer of bad vibes, but chances are, if you live in a developing country, you’ll probably get the short end of the stick.

To demonstrate my point, let’s focus on Cyclopip‘s favorities commodities–food!

Commodities aren’t just those precious metals and liquids. They also include things like sugar and coffee beans, the basic ingredients for that 31-ounce cup of coffee you get daily from Starbucks. But what you don’t know is that when you buy that giant cup of java, only a very small portion of what you spend actually covers the price of the commodities (sugar, coffee beans, etc.) that went into your drink.

So what are you mostly paying for if not the basic ingredients? A huge chunk of what you pay actually goes to other things such as taxes, labor, and of course, the company’s PROFITS! This holds more truth in developed countries than anywhere else. You see, commodities only make up a small amount of the total cost of food in developed countries. So basically, if commodity prices rise, it tends to just have a small impact on the prices of food… in developed countries.

But this isn’t the case in emerging nations. Commodities comprise a larger portion of the total cost of food in emerging countries. In other words, food prices are more likely to mimic commodity prices.

Studies also show that consumers in developing countries also spend a greater percentage of their total income on food. So it’s likely that people living in fast-growing emerging countries will feel the added price pressures (a.k.a. INFLATION) more than those living in developed countries.

So we’ve established that when commodity prices are rising, it could lead to stronger inflationary pressures. What could this mean for monetary policy?

In my last article about ECB interest rates, I mentioned ECB President Trichet’s headaches over rising prices. The euro zone’s inflation rate treaded the 2.2% level in December, which is above the ECB’s comfort level of 2.0%.

Central banks usually combat hot inflation with higher borrowing rates, but in the euro zone’s case, a hike in interest rates would further weigh on the region’s already shaky economic recovery. Just imagine raising the borrowing rates in Greece and Ireland! Those economies have enough financial problems on their plates without the additional burden of lower GDP growth.

And the trouble doesn’t stop with the euro zone. Bank of England member Andrew Sentence also recently highlighted the BOE’s dilemma between rising prices and low economic growth. The U.K.’s inflation rate rocketed to 3.7% in December, which is a lot higher than the BOE’s 3.0% target. Raising interest rates would’ve been a good idea, if only the U.K. economy wasn’t also wrestling with low consumer demand and economic growth prospects.

It’s a good thing that monetary policy isn’t the only solution. Emerging economies have been quicker at getting creative in handling rising food prices. India, for one, extended its bans on exporting cooking oil; South Korea has lowered its import tariffs on some food items; and Indonesia has been encouraging its locals to plant more food.

The recent upsurge in commodity prices might look a lot like history repeating itself, but that doesn’t mean that we have to use the same tricks to tackle the problem. More options are available to policymakers today, which means that there is a bigger chance of solving them in a shorter amount of time.