Reading the Volatile Tea Leaves: Inflation, Commodities and the Supply Chain

Over on Spend Matters' sister site, MetalMiner, Stuart Burns recently took a look at the relationship between inflation and commodities (see Part 1 and Part 2 of his commentary). Stuart's not the only one to consider the intersection of the two. Last week's Economist ran a story looking at the link between inflationary price pressures, particularly in emerging markets and booming commodities such as copper. One of my key takeaways from the article is that inflation is almost a forgone conclusion in certain markets as base commodities begin to work their way through the supply chain. Yet it's not that simple. In the area of metals, specifically, Stuart notes that, "Precious metals and increasingly copper are seen as hedges against inflation, pushing metal prices up," but that to understand inflation and commodities -- and the relation of the two -- it's critical to distinguish between core and headline inflation.

Stuart notes, "core inflation is a measure of consumer price increases after stripping out volatile components such as energy and food. It is indirectly a measure of the gap between capacity and utilization both in industry and services." This contrasts with head inflation, which, "as defined by investorwords.com is price inflation that takes into account all types of inflation that an economy can experience." Further, "Unlike core inflation, headline inflation also counts changes in the price of food and energy." Given the importance of these two inputs in emerging markets, inflationary numbers may often seem higher, if reported in "head" terms, than the true impact of inflation on the extended manufacturing and durables supply chain.

But where does all of this leave us from a commodity price forecasting standpoint? According to Stuart, "Credit Suisse is predicting base metals to increase further with copper up by 20 percent in 2011 and precious metals up, led by palladium increasing by a third, but the rise will be less than in 2010. Importantly, agricultural products will increase in 2011 by less than in 2010, with USD increases of 10-20 percent partially offset by appreciation of emerging market currencies, either deliberately (as in the glacially slow increase in the Chinese RMB) or the domestically unwanted appreciation of the convertible Brazilian Real." He summarizes, "the takeaway is that both metal and agricultural prices, though likely to increase further in 2011, are showing signs of abating and that, providing emerging markets in particular do not overreact, the impact on core inflation will be low and headline or CPI inflation should decrease later in the year."

- Jason Busch

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