Monetary Policy and Heightened Price Volatility in Raw Materials Markets
By Robert Higgs • Saturday January 19, 2013 11:53 AM PDT • 13 Comments
Despite the Fed’s breathtaking increase of base money since the autumn of 2008, the money stock as measured by conventional concepts such as M2 has not increased greatly, and hence, as ordinary quantity-theory-of-money thinking would lead us to expect, inflation as measured by conventional concepts such as the consumer price index (CPI) has been fairly tame during the past five years. Between December 2007 and December 2012, the CPI for all items increased only 9.3 percent. As the chart shows, this increase represented a continuation of a slow-but-steady inflation trend that extends back to the early 1980s.
This modest consumer-price inflation serves as one of the major bases for the Fed’s continued “quantitative easing” and the government’s ongoing “stimulus” spending. The idea is that because inflation seems so well contained, additional monetary ease, near-zero interest rates, and huge government deficits will affect primarily income and employment, rather than the price level.
This conventional macroeconomic thinking, however, by virtue of its highly aggregative view and its reliance on macroeconomic models with no place for capital, fails to alert policy makers to other effects—almost certainly pernicious effects—that their policies are creating.
One form of evidence of such effects appears in the asset markets, where the rate of price increase has been much greater than it has been in the markets for final consumer goods. As Austrian business cycle thinking suggests, these effects have been greatest in the markets for the goods most distant from final consumer products and services, especially in the markets for raw commodities.
As the chart shows, the producer price index (PPI) for crude materials has followed a quite different historical path from the CPI. Since World War II, it has passed through four distinct phases: I, no-growth stability from the late 1940s to the early 1970s; II, rapid increase in two bursts between 1972 and 1981; III, no growth (but with much greater variance than in phase I) between 1981 and 2001; and IV, rapid growth with even greater variance from 2002 to 2012.
Austrian thinking associates the rapid run-up of crude materials prices in phases II and IV with a flight from monetary assets, whose real values are falling or expected to fall. Investors seek the safe haven of real assets as the Fed engages in sustained easy-money policies. In addition, producers bid up disproportionately the prices of “early stage” goods required for undertaking the longer-term projects that artificially reduced interest rates encourage.
Whereas the CPI increased by 30.2 percent between December 2001 and December 2012, the PPI for crude materials increased by 166.4 percent during this period .
With the onset of the financial panic in the second half of 2008 and the economic contraction that accelerated between mid-2008 and early 2009, the PPI dropped almost by half. Since then, however, crude materials prices have increased relatively rapidly, rising by 58 percent between March 2009 and December 2012, far outpacing the increase in the CPI and maintaining a rate of increase comparable to that between 2002 and mid-2008.
Between the early 1980s and 2007, mainstream economists came to speak of a Great Moderation in business fluctuations and the rate of inflation. They spoke too soon, and they confined their view of price behavior too narrowly. Had they been alive to the importance of asset markets and to the link between monetary policy and price change in these markets, they might have noticed that all was no so well as they imagined when they heaped accolades on “the maestro” Alan Greenspan for having engineered this seeming conquest of inflation and produced this miracle of monetary micromanagement.
As anyone who ponders the movements of the PPI from the late 1940s to the present can see, things are currently far from placid on the price front. In the markets for raw materials, the past decade has been the exact opposite of a “great moderation,” and these wild swings have occasioned tremendous difficulties and required wrenching adjustments by many different kinds of producers. Yet scarcely have they made one adjustment when another one cries out for their attention. Such a violently variable, impossible-to-forecast price environment has necessarily brought about a greater volume of business mistakes and a heightened reluctance to embark on new enterprises and to make new long-term investments in existing firms. For such paralyzing uncertainty, we have policy makers at the Fed and in the federal government to thank.
Tags: American History, Austrian School of economics, Business, Economics, Federal Reserve, Inflation, Money and Banking, Uncategorized 
“One form of evidence of such effects appears in the asset markets, where the rate of price increase has been much greater than it has been in the markets for final consumer goods.”
Would this disparity (between raw material costs and pricing power of finished products) result in the “margin compression” – shrinking profitability – that we are beginning to see among consumer and industrial companies?
Kreditanstalt | Jan 19, 2013 | Reply
I would argue very strongly that the cause is a little different. Raw material prices, along with all commodity prices, have increased along with other asset prices in recent years as Wall St. began using that asset class as part of it’s investment targets. In the last 30 years asset prices have risen more than consumer prices because most of the new money created by the Fed/banks is used by Wall St., not by the real economy. Most money created never touches the real economy. And more specifically, it is credit, not money, driving the asset prices. Credit growth far outpaces money growth, and correlates strongly with asset prices.
Kel | Jan 20, 2013 | Reply
It is also interesting to note that Excess Reserves of Depository Institutions continue to remain at fantastically-high levels, in contradistinction to the historical trend of zero held in excess. With interest rates as low as they are today, the conventional wisdom is that banks would have every incentive to loan out the money in order to realize a decent return from productive investment somewhere... Is this hesitancy to leverage on the part of commercial banks also indicative of regime uncertainty caused by new financial regulations and the CFPB? (i.e., Dodd-Frank)
Corey Vollinger | Jan 21, 2013 | Reply
It seems that these physical raw materials, combined with low interest rates would have resulted in massive inventory increases. I have not seen any data, perhaps by not looking in the right places, that shows significant inventory increases.
With increasing prices and increasing instability, the optimal amount of inventory would increase to decrease the risk associated with instability.
Dallas Weaver | Jan 22, 2013 | Reply
I would respectfully submit that the “tame” inflation numbers as concocted by the federal government are bogus, smoke & mirrors.
Also, those of us in the middle, between the producers and the consumers, are getting walloped by increasingly smaller profit margins in an effort to hold on to our market share. I can only eat price increases from my suppliers for so long. With the government taking a bigger piece of my profits, while increasing my operating costs via regulation, the end game is higher consumer prices. Which is happening, but masked by BLS magical statistics.
BillyBob | Jan 29, 2013 | Reply
One analogy to explain looming inflation might be to consider a flood control dam. The water that builds up behind it during the winter and spring could be considered QE1, QE2, QE3, etc. The face of the dam would be the current moribund economic activity indicating a very low velocity of money as exampled by such questions as “Why do I want to borrow if no one wants to buy? or “Why do I want to buy when I don’t have a job?” Now stagflation happens when the reservoir gets so full with QE’s that some water just has to go over the top, even though economic activity remains anemic.
But when the economy picks up money begins to actively circulate. Water infiltrates the face of the earthen dam just as money moves through society. Now the increased velocity of money reveals the previous latent power of the QE’s, and the increased pressure shatters the face of the dam. Just as a wall of water scours out the stream bed and washes all before it, inflation now rages through the economy and destroys people’s financial asset values and their purchasing power.
Nolan Nelson | Jan 29, 2013 | Reply
“...rapid increase in two bursts between 1972 and 1981...”
Isn’t this index energy-sensitive? When I read the above quote, the first thing I thought of was OPEC.
~FR | Jan 29, 2013 | Reply
Nolan, I agree with your dam analogy, however your source of the water is flawed. State money (Fed purchases through QE1, QE2, QE3 or other means) is only roughly 15% of the money supply. The other 85% of it comes through credit, which has been anemic the past few years. If/when the economy picks up, it is the money from credit expansion, not Fed purchases which will be the primary cause of inflation.
Josh | Feb 8, 2013 | Reply