By: Alen Mattich – Source: The Wall Street Journal

Is the latest surge in commodity prices a tanker (or bulk carrier) half empty or half full? Optimists might argue that the asset class is responding to a global economic revival and, particularly, to demand emanating from booming emerging markets. In other words, rising prices are a barometer of economic health.

What’s more, because commodities tend to be priced in dollars and because the U.S. currency has been depreciating almost universally, the impact on economies beyond the U.S. should be minimal, except in countries which peg their currencies to the dollar, where it will prove to be inflationary. But by the same token, it should ensure the U.S. doesn’t drift into deflation. Which is just what the Federal Reserve wanted when it launched its latest round of quantitative easing. Pessimists worry either that the jump in commodity prices heralds excessive inflation rates, with those on the extreme talking about hyperinflation, or that it will prove to be deflationary. The excessive inflation argument hinges on expectations that the Fed’s balance sheet, massively swollen by QE, will feed through to generalized price rises in short order. This seems unlikely, particularly as the banking sector remains reluctant to lend.

There’s more of a case to be made that commodity prices are being speculatively driven and, as happened in 2008 when the Fed’s rapid loosening of monetary policy triggered a previous speculative spike, the increases will knock the stuffing out of a still fragile U.S. economy and thus have a negative impact globally as well. The dollar index and the dollar/euro exchange rate have dropped by around 10% from mid-summer levels, not long before Federal Reserve chairman Ben Bernanke began to openly mull another round of quantitative easing. Over the same period, the CRB commodity index has jumped by around a quarter. So, rising commodity prices are not just having an impact on dollar-bloc countries. What’s more, it’s clear that dollar weakness doesn’t tell the whole story about commodity prices. Sure, expectations about U.S. recovery are probably having an impact. But this is likely to be overstated, particularly as previous experience with quantitative easing has shown it to have only a modest impact on underlying economic growth.

Although all commodities have performed strongly, some have moved harder and faster than others. For instance, agricultural commodities have hit record highs, breaching 2008 peaks. And to be sure, there have been weather-related reasons for supply constraints in some softs like sugar. But at the same time there hasn’t been a big enough jump in final demand to warrant the near doubling of agricultural goods prices, according to Julian Jessop at Capital Economics. It’s even harder to justify some of the moves in industrial commodities, while recent price action in precious metals, particularly silver, suggests a lot of the price gains have been purely speculatively driven.

Oil has been better behaved and is nowhere near the $140 a barrel peak it breached during the 2008 speculative blowout. Even so, crude is flirting with $90 a barrel, a doubling in prices over the past year and a half.

If these commodity moves have more to do with speculation than underlying economics, as in 2008, then the results are also likely to be similar. Which is to say they will prove to be deflationary, despite an initial uptick in costs. While it is undoubtedly true the credit crunch was triggered by the Lehman Brothers bankruptcy, the global economy had already been slowing, led by the U.S. recession, in no small part because rising prices were starting to crimp already vulnerable demand. Consumers’ buying power will be eroded as will earnings among firms unable to pass on higher input costs.

This suggests investors ought to be concerned about another global slowdown, led, once again, by the U.S., early next year. And, when that starts to register, another collapse in commodity prices.