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15 April 2024

How commodities hit inflation

By Paul Murphy


A recent headline on the Reuters newswire caught my eye: Saudi Q4 inflation jumps above six per cent in five cities. The accompanying story made the point that the Saudi Government is limited in what it can do to fight inflationary pressures, since the currency’s attachment to the so-called “dollar peg” means it has to mirror US interest rates, which are coming down fast to ward off an American slump.

Yet it struck me that governmental impotence in the face of spiralling prices is a much wider problem than countries with exchange rates linked to the greenback. It’s a global issue now.

John Kemp, an economist at a London brokerage, Sempra Metals, published a fascinating primer on modern inflation recently making a penetrating – yet utterly simple – point: the single most significant factor in determining inflation has moved from labour to commodities.

In the West, the ability of organised labour to demand inflation-busting wage increases was largely wrecked by the likes of Margaret Thatcher and Ronald Reagan. This helped usher in the modern era of low inflation – a trend that was reinforced by the growing availability of cheap labour as economic pressures globalised, most notably with the awakening of China. In fact, “bad inflation” (anything above, say three per cent) looked to have been abolished. As Kemp puts it: “Raw materials have replaced labour shortages as a key inflation-generating bottleneck in the world economy.”

During the last commodities boom in the 1970s, there was judged to be excess investment in capacity – depressing prices. While that investment has now been absorbed, there has been precious little investment in the meantime, leading to a dearth of new capacity despite surging prices.

But Kemp identifies another fascinating factor: “Generational change at the top of oil and mining companies, with MBAs taking over from engineers.”

The point of the Sempra Metals man is that management focus has moved from things such as output maximisation and cost control, to issues such as marketing, pricing and shareholder return.

Executives are simply more sophisticated, using corporate consolidation to increase pricing power, while simultaneously taking a disciplined approach to investment in capacity.

Along the way, this investment in new capacity, albeit controlled, introduces more upward pressure on other raw materials needed to construct plant and the like.

Furthermore, while the inflationary pressure gauge of old – labour – is still segmented along national lines, controlled by work permits and the like, commodity markets are almost fully liberalised and prices are set worldwide.

Says Kemp: “As the source of inflation has shifted from the labour market to commodities, inflation has become a global rather than a national phenomenon. Inflation is now being transmitted from one economy to another through the trading system in raw materials and manufactured items.”

The consequences of this are profound. For a start, it is clear the US now has only limited control over its own inflation rate, since all countries now draw on the same commodity resources – the price of which is largely outside official US hands.

Contrary to comments coming out of the Federal Reserve this week, there is no particular evidence the trend in commodity prices is going to be reversed any time soon – witness the fact that the crude prices continues to soar just as the evidence of US economic slowdown continues to mount. There are also trends among institutional investors to take into account, with a rampant reallocation of money from bond markets into commodity funds of one sort or another adding yet more upward pressure on prices.

For his part, Kemp sees the global economy entering a period of stagflation, which will run through the first half of the year and extend into the second half. His conclusion is chilling: “The Fed’s inaction, in particular, will also produce a further devaluation in the dollar, which will add to upward pressure on prices. An environment characterised by stagflation and a weakening dollar is highly favourable to further increases in commodity costs. Investors will continue to favour commodities as an asset class rather than inflation-hit bonds. Commodity prices are already pushing higher across the board and look set to establish new peaks during the next few months. But the backdrop is likely to change in H2.

“If the slowdown spreads from the United States to Western Europe and China, commodity demand and hence prices and inflation will moderate. If not, the continued surge in prices and inflation must eventually draw a response, crucially from China. One way or another, the global economy has gone beyond its capacity for non-inflationary growth. Global growth [and commodity demand] will have to slow in the next six months if inflation is not to rise to levels last seen in the 1970s [undoing 25 years of progress].”
Paul Murphy is Associate Editor of the Financial Times