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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Suppose, however, that the pork producer spends the dollar on feed and then the feed dealer buys a car including that dollar. This one dollar has now created three dollars in economic activity, for a money multiplier or velocity of three.
The velocity of money is currently less than one; we're not even getting one dollar in economic activity for one dollar placed in the economy. This creates a potential cycle of deflation because people will not spend until they are assured that the assets they purchase will not decline in value. This is also why initial stimulus packages to banks have been ineffective. With no spending, the stimulus simply does not move beyond the banks.
Something must be done first to change the perception that prices will be cheaper in the future and to reduce the erosion of asset values. This is why the new stimulus plan may help because it directly spends money; the money multiplier almost certainly must increase.
As an aside, the money multiplier has been in a downward trend since 1986. This is the result of an increase in foreign purchases by the United States. Essentially, once a dollar leaves the United States, it has no further impact on the U.S. economy.
A common concern is that renewed spending may re-ignite inflation. As Figure 1 shows, money supply has dramatically increased in the past few months, which is the original problem that led to inflation and could potentially do so again. I expect prices to turn around when money velocity picks up. I watch this statistic every week as a key indicator of a change in spending. However, increasing unemployment acts as another downward force on demand, so it remains to be seen if the most-recent stimulus plan can turn this around.
The fundamentals of macroeconomics suggest we must get productivity back in line with money supply. My concern is that policy-wise, we are putting too many variables into play, thus reducing the ability of “the market” to respond rationally to the fundamental macroeconomic signals and creating distortions that don't allow for adjustments. The potential with increasing monetary stimulus is to swing wildly from deflation to inflation.
Strategic Risk Management Considerations
How can we respond to a volatile macroeconomic market when it feels as if there is no control? The macroeconomic factors will trickle down to pork and other specific commodities through inflationary or deflationary pressures. Keep an eye open for these key implications:
In the short to intermediate run, demand will continue to soften, both in the United States and internationally because of unemployment and overall deflationary pressure leading to downward price pressure, even as pork supplies decrease.
Velocity of money is a key indicator of when prices may begin to rebound, as it reflects increasing economic activity. At this point, commodity prices are likely to begin to rise again because of the high money supply and stimulus plans.
Price volatility will be high. It is also likely that all commodity prices will move systemically in the same direction with inflation. Therefore, it becomes increasingly important to manage price risk of inputs and outputs, vs. one side or the other. This was the lesson learned by many long hedgers of commodities when prices were high and then moved systemically lower.
With any form of deflationary pressure, assets such as land values and commodities tend to decline in value. This can rapidly erode balance sheets, particularly for leveraged assets. Therefore, it is important to monitor liquidity and credit availability. Agriculture runs the very real risk of land prices dropping in the coming year or two. Fortunately, it is entering this period with a solid balance sheet.
Cash is king in deflationary periods. But, if inflation picks up, then assets are king. If asked to make a longer-run, two- to five-year projection, I think agriculture will do extraordinarily well as inflation percolates back into the markets. Having hard assets, such as land, will be a very good place to be.
Systemic risk dominates unsystemic risk, so the concepts of portfolio diversification and hedging reduce the ability to manage risk overall. No one can completely avoid asset loss due to deflation or cash erosion on inflation. Maintaining financial flexibility can be a critical way to respond to macroeconomic events.