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Too Sanguine About Commodity Prices

On the surface, it seems contradictory: the Federal Reserve is sanguine about the inflation outlook at a time when commodity prices are at historic highs.

Commodity prices are a leading indicator of inflation, not simply because they get passed along in output prices, but they are a reflection of broad-based demand.

Strong final demand reflects itself in strong demand for industrial metals and other commodities used as inputs in production, acting to pull up their prices. The recent upswing in production in the U.S., and even more particularly in China and the rest of the world has been behind the pronounced increase in commodity prices.

It's a trend that could have lasting implications: demand has picked up, commodity prices show it and consumer inflation is likely to follow

The Fed, however, tends to focus on the inflation final consumers face and has been relatively complacent about the recent sharp rise in commodity prices, despite the fact that the Commodity Research Bureau's futures index is at a 24-year high.

Some of the Fed's comfort simply reflects the fact that the core measures of consumer prices have been behaved for so long. Part of it is also due to non-commodity influences on final prices, such as productivity increases, which moderate the commodity effect.

For instance, on Tuesday, Fed Governor Ben Bernanke noted a series of upward inflation pressures including energy, commodity and import prices, but kept the focus on prices as measured by the core personal consumption expenditures price index. "My own guess is that core PCE inflation in 2005 will be slightly higher than its 2004 rate of 1.6%, though likely remaining within what I think of as the `comfort zone' of 1% to 2%," he said...

The recent rise in commodity prices is an indicator of future increases in the inflation that the Fed watches. That's the view of Anirvan Banerji, research director at the Economic Cycle Research Institute in New York. ECRI's Future Inflation Gauge uses the Journal of Commerce-ECRI industrial price index as one of the seven composite indicators.

ECRI prefers using the JOC index because, while the CRB index is restricted to exchange-traded commodities... The JOC index is restricted to industrial materials..., which are important to production (benzine is an input in plastics) but not traded on commodity exchanges.

"The reason we use commodity prices in the (future inflation gauge) is not simply because there's a cause and effect between commodity price rises and broader inflation, but rather because it provides a signal of inflationary pressures," said Banerji. "A broad-based rise in commodity prices is an early signal of the state of demand in the economy."

The ECRI view is that U.S. inflationary pressures are currently in a cyclical upswing. Moreover, Banerji adds that "the Fed is behind the curve, but not far behind and (the Fed is) not unhappy about that."

After all, he pointed out "not so long ago the Fed was worried about deflation. I think we're way past deflation now."