The rebound in oil and commodity prices could derail the global economic recovery
Just about everything in the economy is inter-related. No sooner do you think that you can see the way ahead than the reaction to a previous change comes along and hits you in the face.

The factor that ought to trouble the markets at the moment is the rebound in oil and commodity prices. Could this derail the economic recovery which seems, to many observers, to be just around the corner?

There has been a significant and broad-based increase in commodity prices since March. In dollar terms, the S&P Goldman Sachs Commodity Index has risen by more than 40pc, while since December of last year, the Baltic Dry Freight Index, which is an indicator of the price of transporting bulk commodities, has risen by 425pc.

The surge in commodity prices has been led by industrial metals such as lead, nickel, copper and zinc, which have risen by between 55pc and 72pc. Oil prices have lagged only slightly behind, with Brent crude rising by 43pc and reaching a level more than double the lows of $35 per barrel seen in December last year. Agricultural commodity prices have also risen sharply, notably soybeans (up by almost 50pc), with corn, wheat and cocoa rising by between 10pc and 20pc.

In contrast, precious metals have failed to shine, with gold prices essentially unchanged from where they were at beginning of March. Among the very few commodities to fall in price have been live hogs (a casualty of swine flu) and natural gas (reflecting improvements in supply).

At the moment the threat to the economic recovery from these rises in commodity prices is minor. Despite the recent rally, prices are still well below the highs reached during the summer of 2008. Oil prices, for example, are still 50pc lower than the peak of $147 seen in July 2008.

The dangers arise from the possibility that these rises in commodity prices might continue. If that were to happen, then the sharp falls in inflation which have occurred in several Western countries and which have looked set to go further, would go into reverse. That would have two adverse effects. First, it would threaten to increase bond yields, which are already under upward pressure. Higher bond yields would themselves tend to weaken the economy. But in today's circumstances they would be worrisome because governments, including our own, have to raise enormous sums from the bond markets. Higher bond yields increase the cost of government funding and thereby tighten the fiscal screw still further.

Second, higher inflation would drain purchasing power from Western consumers and companies and consequently cause them to reduce their spending on other items, thereby worsening the recession. This, too, would have the effect of increasing government budget deficits still further.

To appreciate whether such a scenario is likely we have to delve into what is behind the increases in commodity prices. Part of the explanation is purely technical: the decline in the dollar. Since the beginning of March, it has fallen by around 15pc against the pound and over 10pc against a broader basket of currencies. So it is natural that those things quoted in dollars should go up in price.

However, commodities have still risen in sterling terms: oil prices have risen from £35 per barrel to £44 per barrel since the beginning of March. So higher commodity prices are not just a currency story. There is something else going on.

Could that something else be investors' fear of higher inflation? Physical commodities have often been perceived as a store of value and can act as an inflation hedge. There have been concerns that quantitative easing and expansionary fiscal policies could prompt a surge in inflation. These concerns could well explain some part of the rally in commodities.

But if this were the story how would you explain the pattern of sharp differences between different commodities and, especially, how would you explain the performance of supposedly the best inflation hedge of them all, namely gold? Gold has underperformed the commodity sector by a considerable margin. Nor have inflation expectations in the bond markets picked up enough to be consistent with the idea that the commodity rally has been based on fears of sharply higher inflation.

I reckon that the decline in the dollar and the rise in commodity prices have been driven by essentially the same factor – namely the growing confidence about economic recovery, which has both raised the expected level of future demand for commodities and reduced the safe haven appeal of the dollar.

The difference in price performance between commodities is consistent with this story. Those that are the most sensitive to changes in economic conditions, such as industrial metals, have outperformed the overall index. Oil is heavily correlated with the economic cycle and has also outperformed since March. This suggests that the rally in commodity prices has more to do with revisions to global growth expectations than inflation worries.

But there is an element of circularity at work here. The increase in global commodity prices reflects the expectation of global economic recovery, yet higher commodity prices will themselves impede that recovery. I suspect that we will not see both a strong global recovery and much higher commodity prices. It is possible that recovery will start to build without commodity prices going much higher. After all, the previous surge of oil prices in 2008 seems to have had a major effect on demand. BP's Statistical Review of World Energy reveals that global oil demand fell last year by 0.6pc, the first annual decline since 1993.

Moreover, last week the International Energy Agency forecast a further 3pc decline in demand this year. And stocks of oil have risen sharply since March. This is consistent with the idea that some of the surge in oil prices is speculative, just as was the case last year. If so, then oil prices could readily fall back again, just as they did before.

For what it is worth, my hunch is that the recent commodity price rally will peter out and the downward progress of inflation will continue.

The next bit of UK inflation news comes on Tuesday. I reckon that CPI will fall to about 2pc, its target level, with further falls to less than 1pc by the end of the summer. My money is on low inflation being sustained for some time. But for that to be right, the recent commodity price rally will have to peter out pretty soon.


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