I have been bearish on the outlook for commodity prices over the past two years. In recent months there have been further significant falls in most commodity markets. Most strikingly the oil price has fallen steeply with Brent crude dropping from $115 per barrel in June 2014 to $64 in December 2014 and below $40 in December 2015.
This is a direct result of weak demand in China, other emerging economies, and the Euro-area, together with the consequence of new supplies from US shale oil and gas suppliers, plus the decision of OPEC not to cut production.
Other industrial commodities have seen comparable price falls. For example, imported iron ore in China has fallen from US$180 in 2011 to below US$40 per metric tonne in December 2015 while Australian coking coal prices have fallen by comparable amounts.
Finally, precious metal prices have been declining with gold and silver prices subdued, but steep falls in platinum prices over the past five years, and a 40% fall in palladium prices over the past year.
This is all consistent with the relative softness of global demand resulting from the sub-par growth of major economies and the slowdown of emerging economies as they reduce emphasis on export-led growth models. Looking forward, commodity markets are not likely to strengthen over the next year as inflation will remain low and economic activity levels will moderate at best in my view.
In the financial markets there is a widespread misunderstanding about the stance of monetary policy. Most economists and analysts tend to judge monetary policy by the level or direction of interest rate changes.
However, interest rates are not a good measure of the stance of monetary policy. If monetary policy i.e. monetary growth is eased, interest rates will fall initially but later, after the economy recovers and inflation rises, rates will rise. The longer term and more important effect (the “Fisher effect”) of easy money is higher interest rates not lower rates.
Conversely, if monetary policy is tightened interest rates will rise initially, but then after the economy has slowed and inflation has fallen, interest rates will fall. So the longer term and more important effect of tightening monetary policy is lower rates not higher rates.
That is why interest rates today are highest in countries like Argentina and Venezuela and why interest rates are lowest in countries like Japan and the eurozone.
It follows that what is needed to avoid deflation is faster growth of the quantity of money. It is not enough simply to lower interest rates to zero as the ECB has done. The reason is that by merely following market rates downwards, central banks can remain essentially passive, failing to provide the monetary expansion that an economy needs to grow.
The low interest rates in the eurozone and in Japan are the result of the second phase of a prolonged period of tight money policy – that is, slow money growth – not the first signs of easier – that is, faster money growth. It is hardly surprising that in these circumstances Japan and the Euro-area have been confronted with deflation in recent times.
With the Fed in the US moving to raise interest rates (to normalise but not tighten monetary policy) in 2016, the critical issue will be whether money and credit growth can be sustained at 6-8% p.a. (their recent growth rates).
If the commercial banks are able to maintain these money and credit growth rates, then even if bond and equity markets are jolted by the initial rate hike(s), the economy will, in my view, be able to shrug off the interest rate hikes, expanding for several more years before the business cycle hits a peak.