Evan Soltas
Aug 11, 2012

Hot Commodities

Vegetable Market in The Evening
The prices of key agricultural commodities have risen substantially in recent weeks. Corn has broken the $8-per-bushel mark in spot markets -- a rise of 25 percent in two months -- and soybeans, a lesser-known staple crop used in animal feed and processed foods, cost 60 percent more than they did at the start of the 2012. Wheat, a fellow staple crop which could have been a substitute for corn and soybeans, is itself up by roughly 50 percent this quarter. Exchange-traded funds which track a fuller basket of agricultural commodities are up 15 percent from their lows in June, which they plumbed amid fears of a global economic slowdown.

Temporary shocks to supply have propelled much of these price increases. Most importantly, severe drought in the United States and adverse weather conditions abroad have sharply reduced harvests. Prices should decline significantly over the next three years, futures markets predict, as crop yields return to normal.

But the increase in commodity prices is hardly a one-off blip. Over the last decade, the real price of commodities has risen 20 percent, according to a comparison of the commodities component of the Producer Price Index against the Consumer Price Index.Consumers and producers have both noticed. A regular gallon of gasoline goes for $3.65 on average in the United States, with prices at the pump back at the elevated range seen before the recession. The price of iron and steel is more than double what it was a decade ago.

This comes as a sharp reversal from the 80s and 90s, when two decades of oil glut, strong harvests, and geopolitical calm left commodity prices in a lull. The last decade bears some resemblance to the oil shocks of the 70s, although restrained aggregate demand growth and negligible upward pressure on wages have prevented the inflationary spiral seen in those years.

Controlled inflation, however, does not change the fact that the increase in the real price of commodities is, in many ways, historically exceptional. As far as supply shocks go, the ongoing one is large in magnitude and particularly long in its duration. A stylized fact about commodity prices is their tendency to surge sharply and then abet slowly; double-digit percentage increases made in a matter of months will unwind over years, as demand softens and shifts into substitute goods and supply grows to accomodate demand.

What is most unusual, in fact, about the last decade in commodities is how false that has been. The upward march in prices was only briefly interrupted by the sharp downturn in global trade in 2009, and despite weakness in developed and developing countries alike, commodity prices have provided scarce relief.

Economists widely credit vigorous growth in emerging markets for this environment. Though others point to the impact of speculators in financial markets, tight inventories belie that argument and suggest that the consistent upward direction of commodity prices is driven by true (i.e. non-speculative) demand growth outpacing supply growth.

It is worth asking whether the world should expect commodity to prices will remain high. The last time, economists projected prices to remain high, and some even saw in them an imminent threat to civilization.

Economists are far more sober today, having witnessed in large part the vindication of Julian Simon's "cornucopian" vision. Maybe they should not be quite as sanguine. What looks like a supply shock to the developed world today, however, is more truly a demand shock at the level of the global economy, where the supply of resources is increasingly diverted to thirsty developing countries.

Transient shocks to supply -- witness OPEC's cut in oil production -- and high inflation expectations determined the commodity-price increase of the 1970s. That is not as true today: commodity producers are operating near full capacity, and the increases in commodities demand are driven by real needs for resources rather than a response to inflation.

OPEC could have restarted production more easily in 1973 and 1979 more easily than new production capacity can be developed today. The Federal Reserve could and did adjust inflation expectations downward in the 1980s, but it cannot stop Chinese builders from constructing hotels in six days, nor the insatiable demand for raw materials such behavior requires, in aggregate, across developing countries.

Moreover, it may be a challenge for supply to keep up with current rates of demand growth. The gains from "Green Revolution," which led to enormous increases in crop yields in the developing world during the 80s, have been expended. Although progress in natural gas and unconventional oil is encouraging, especially in the United States, the data require heroic assumptions to make plausible a return to low real commodity prices. Alternatively, of course, they require a sustained slowdown in emerging markets, with -- it must not be forgotten -- the terrible costs that would entail on the quality of life for billions of people just beginning to aspire to something better.