Commodities Stoke Inflation Fears

On April 30th, the Federal Reserve announced a cut in their main interest rate by 25 basis points, to 2% from 2.25%. This is the seventh such cut by the US central bank since the beginning of the credit crunch some eight months ago, totaling 3.25% in cuts to the key rate that banks charge each other for overnight loans. These cuts have been made in an attempt to lower mortgage rates to help bolster the real estate market. As the fragile US economy staggers towards recovery, two major agents are working against American consumers: record inflation in food and energy. What can we expect in the future for these troubled yet lucrative markets? In the short term, volatility will probably continue to dominate, but in the middle term inflation may take precedent over combating the slowdown, both for the central bank and regular consumers. Just as the Fed began to cut interest rates, the dollar's 5-year slide accelerated, pushing commodities that are priced in dollars like oil down relative to other currencies. This self-reinforcing process means that their futures markets are cheaper to buy in other currencies, which has led to a massive increase in speculation by flustered investors looking for a safe haven for their assets. If the Fed were to continue to cut interest rates further, this process could keep consumer spending, which accounts for two thirds of the US economy, tamped down for some time. In March, spending only increased more than projected (0.4%) because of highly inflated energy and food costs. In addition, businesses have continued to feel the pinch of higher secondary costs that affect many other prices, even as output continues to fall. Nevertheless, the strong March activity index from the Institute for Supply Management was still stronger (48.6, with 50 meaning zero growth) than many economists had expected, implying some underlying resilience. The lingering question remains: what is the Federal Reserve doing by cutting an inter-bank interest rate? It appears now that they are stoking inflation through price distortion, if the positive effects thereof (some stabilization of the troubled financial sector) is ignored. By making dollars cheaper, the value of oil and food is cheapened and necessarily must rise accordingly. Now exchange rates between the dollar and the euro have statistically matched fluctuations in oil prices for 52% of the last six months, compared to less than 1% for the years between 1999 and 2004. Investors and speculation have turned commodities into a superb place to dump cash, but such simplistic reasoning should be setting off alarms in the wake of the credit crunch. In Washington and abroad, few have challenged the Fed's decisions, which have not been as noticeably correlated to price increases until recently. That may change as eurozone inflation remains stubbornly above target levels, mostly because the European Central Bank takes energy and food into its purview. While the Fed are still supposed to fight inflation first, their smaller focus means that their culpability is limited. As the election looms over Ben Bernanke's head, he is likely receiving pressure to stabilize first and ask questions later. However, a housing bubble and top-teir mismanagement led to the credit crunch now dragging down global growth. No one is looking to repeat this experience, especially because a commodity bubble is surely the worst kind.