The monetary value of liquid commodities

In modern commodity markets one can exchange money for commodities at almost zero transaction costs. These markets thus reflect not just the supply and demand of the commodity, but also the supply and demand of the currency they are priced in.

Because they combine liquidity with short- and medium-term supply inelasticity, mineral commodities are a good way to hedge a falling currency. When the supply of money increases or is expected to increase, whether because of lower nominal or real interest rates, because the bank that issues the currency is buying government treasury bonds or (like John Law of Mississippi Bubble infamy) mortgage-backed securities[*], or for any other reason, a disproportionate amount of the expected or surprise increase in money supply is soaked up by commodities. Indeed the commodities with the most liquid markets and inelastic supply, such as oil and gold, tend to move in lock-step with each other. Such price movement is strong evidence for the movement being primarily a phenomenon of changing money supply or demand rather than of changing supply or demand for particular commodities. If oil prices were rising primarily due to rising industrial demand for oil, or primarily because oil was getting more expensive technologically to produce (e.g. "peak oil" theory), we'd expect them to move quite differently than gold, which is demanded for primarily non-industrial reasons and has a vastly greater inventory/production ratio on the supply side than oil. That's not what we see -- we see oil and gold moving together, and indeed the price of oil in terms of gold and silver has been practically flat in the recent commodity boom. This is almost entirely due to expected or actual increases in the supplies of the currencies they are traded in (and especially recently in the weak dollar) rather than to "real" factors.

This inflation only slowly percolates into price rises in other goods and services, which tend to be far more rigid than commodities. Wages are particularly rigid. Because the U.S. Federal Reserve and most other central banks regulate their money supplies based on trailing indicators of inflation(e.g. consumer price indices) rather than leading indicators (commodity prices), it is no surprise that their decisions tend to produce boom-and-bust cycles in commodities, and that to a lesser and more delayed extent they cause both general inflation and recessions. No uncommon demand from China or the like is needed to explain the recent commodity boom, just as no such rise in demand or long-term fall in supply was needed to explain the very similar commodity boom in the 1970s. But since most people judge supply and demand of a commodity by nominal price, both in the 1970s and now we get a lot of irrational hysteria about "running out", "peak oil", how our energy industries and consumption are "unsustainable", etc. I'll believe that when oil per barrel doubles or more with respect to gold and silver. When they move together, we're just being fooled by monetary instability, and most of the current disproportionate increase in investment in energy supplies and conservation, whether traditional or renewable, is malinvestment in response to highly distorted nominal price signals, as is the accompanying political bubble of "energy security", conservation enforced through idiotic micro-regulations (e.g. banning traditional light bulbs), and so on.

Another way of putting this is that, when currencies become unreliable as a store of value, commodities take on part of that monetary role. Both oil and gold increase in value by performing this monetary function better than the currency against which they are being traded, better than credit instruments denominated in that currency, and even better, in the short term, than stocks of companies that do business primarily in that currency. The joint movements in oil and gold reflect their value, relative to the currency they are priced in, performing the monetary function of a store of value. Global supplies and industrial demands for minerals are far less volatile than the change in their value in this monetary role. It's the logical emergence of money from barter, but this emergence goes on every day that liquid commodities act as a better store of value than the currency in which they are priced. Contrariwise, as the currency becomes a better store of value than the commodity, these commodities move back down towards just being commodities valued only for their consumption. Thus their exaggerated moves, both upward and downward, in reaction to changing expectations of future increases or decreases in money supply.

Due to their exaggerated moves and the relative rigidity of most non-commodity prices, commodities themselves are an imperfect store of value. They react far more than the general level of prices to both increases and decreases in money supply, or changing expectations of same. If the Fed stops playing John Law and desists from buying bad mortgages, if others besides the Fed soak up all the new Treasuries produced by large federal budget deficits, ifcounterparty risk in credit markets subsides, the Fed can raise rates, sell securities and retire the money, and otherwise take steps to lower the money supply and stanch inflation. In such a case, commodities will react disproportionately on the downside, as they did in the 1980s. If the Federal Reserve can't do these things, dollars and dollar-denominated securities will continue to decline and people will increasingly turn to commodities to protect their nest eggs. All the ads I see and hear for gold these days suggests the peak of a commodity bubble is near, but on the other hand credit markets may worsen due to the continued crashing of the previous bubble (the housing/mortgage bubble), federal deficits may continue to increase, and the Fed may thus buy even more securities, making commodities even more attractive. I'm thus afraid that I have no buy or sell recommendations for you, dear readers. :-)

[This comment is based on a comment I recently made at the Marginal Revolution blog].

* [Obligatory Wikipedia links: John Law, Mississippi Bubble, BearStearns bailout]

[UPDATE: reader Byrne Hobarth has linked to this excellent analysis of the commodities market. This study debunks the theories that trends in supply or consumption demand, very steady over the last century, have greatly changed over the last decade. In particular, increased demand for many commodities such as copper in China has been offset by slows in growth or declines in demand in Europe and the U.S.

The studies' thesis is that the commodity runup is largely just a bubble. The study shows the spectacular rise in commodity derivatives. These represent far more contractual liability or asset than the underlying commodities. Treating commodities as money, this to me looks like a new emergent form of fractional reserve banking, but reconstructed in the investment rather than the banking sector. These derivatives, on this view, act essentially as private fractional reserve currencies, backed by a variety of commodities. The report views all this as evidence of a bubble. It points out we haven't yet seen the consumer inflation of the previous commodity bull. I emphasize yet. Consumer prices are a trailing indicator, and I believe the commodity markets are more rational in anticipating and reacting to money supply increases than they were in the 1970s thanks to the dominance of derivatives. The development of these new kinds of currencies, though prone to the risks and errors of novelty, are largely rational.]