On July 14, 2008, West Texas Crude Oil was priced at $145/barrel, spot corn prices were $6.34/bu. and live hog prices were $73.18/carcass cwt.

On July 16, 2008, a Wall Street Journal (WSJ) headline read: “Bernanke: Inflation is Too High.”

The day after the headline, corn was down $0.28/bu., oil was down $5/barrel and hogs were slightly higher.

On Jan. 16, 2009, two WSJ headlines read: “Shades of 1955 as Consumer Price Index (CPI) Fuels Deflation Fears” and “Inflation in 2008 Slowest Since 1954,” keying in on these historic price changes.

By Feb. 16, 2009, West Texas Crude Oil was $37.51/barrel, spot corn prices were $3.48/bu. and hog prices were $57/carcass cwt.

For these three commodities, the annual difference between the maximum and minimum prices in 2008 was the widest on record — dating back to the 1800s. What caused the seismic shifts in markets in such a short period?

Money Supply, Not Pork Supply

While much of agriculture's attention was focused on ethanol's impact on prices, we now see the underlying factor driving prices was the rising money supply leveraged by credit.

Money supply is the amount of currency the central bank (Federal Reserve Bank in the United States) puts into the economy. Ideally, the money supply is managed in relation to the productivity of the economy — usually measured by gross domestic product (GDP). If money supply increases and productivity does not, then inflation occurs because too much money is chasing too few goods. If productivity increases and money supply does not, then deflation can occur because there are too many products with too few dollars to buy them.

Figure 1 shows GDP, money supply (MS), the ratio of gross domestic product to money supply (the balance of productivity and money supply) and exchange rates, a proxy for the value of the dollar relative to the rest of the world.

As expected, money supply and GDP have both been increasing over time. But beginning in 2001, money supply began to grow relative to GDP as indicated by the ratio of GDP to MS. This correlates with the decrease in the value of the dollar illustrated by the exchange rate. This imbalance led to the rapidly increasing prices (too much money chasing too few goods) seen in 2007 and 2008 and shown by the commodity price index shown in Figure 2.

The primary mechanism for the Federal Reserve to change money supply is to change the federal funds rate, or the rate at which banks can loan to one another.

Figure 3 shows the federal funds rate in the United States from 1980 to present, as well as the level of consumer credit over that period. As interest rates decreased to stimulate the economy after the dot-com bubble burst and 9/11 occurred, consumer credit increased, placing further demand pressure on goods and accelerating commodity price increases.

On July 16, Federal Reserve Chairman Ben Bernanke signaled inflation was too high and that interest rates might rise, thus signaling a reduction in consumer demand caused by less access to credit. This, in turn, caused asset values to decline, reducing equity values relative to debt held by banks — and the credit crunch emerged. This is not to say Bernanke's statement was the mistake. Rather, it was the longer-term inevitable result of increasing money supply and increased credit placed at risk if asset values began to decline.

Credit Crunch and Deflation

The lock-up due to the “credit crisis” is demonstrated by Figure 4, which shows the “velocity of money,” a reflection of how quickly money moves through the economy. This number — also called “money multiplier” — is rarely used, but it speaks volumes about the current situation.

To understand the money multiplier effect, suppose you have one dollar placed into the economy by the Federal Reserve. If this dollar is spent by a car salesman on a pork chop and then the grocer, packer or pork producer stuffed the money in a mattress, the money multiplier would be “one” and not much economic activity is generated.

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