By Hilda Ochoa-Brillembourg
President, CEO & CIO
Strategic Investment Group
Notwithstanding the possibility that more policy intervention in the U.S. economy could make matters worse, I'd dare to suggest a more nuanced, multi-pronged approach to monetary policy. Given that the Federal Reserve (Fed) mandate calls for managing inflationary and employment trends and that inflationary pressures may prematurely hinder sustainable employment gains, it may be time to consider Fed counter-trend intervention in the commodity markets. Assuming the Fed would be able to bring inflation under control when it does rear its head, selling commodity futures to sterilize core inflationary pressures generated by quantitative easing might not only reduce the chances of a stagflationary outcome but might even be a very profitable trade for the Fed.
Selling commodities into increased speculative demand for commodity futures would reduce the self-feeding loop of inflationary expectations and financial speculation in the commodity markets. The Fed has not hitherto engaged in this type of monetary "sterilization," but sterilizing a portion of interest rate intervention would be akin to sterilizing currency interventions as has been done in the past in a few countries to reduce the likelihood of inflation from intervention in the currency markets.
Quantitative Easing 1 & 2 have proved potent but insufficient weapons against recessionary forces. On the one hand, monetary easing and low interest rates have served to boost asset prices but have not been effective in generating capital investment and employment, given other macroeconomic and political uncertainties. And now, two years into the process and arguably running out of time before inflationary bubbles begin developing, sensible economists are concerned that quantitative easing is such a potent tool that it might release hard-to-contain currency, trade, and inflationary pressures, the likes of which are now clearly appearing in the commodity futures markets.
Real demand for commodities in high growth-economies is a fundamental driver of commodity price increases, and there is no reason for the Fed to counterbalance a fundamental trend that would generate additional supply of commodities and employment over time. But a secondary effect of the fundamental demand for commodities stemming from higher growth in the emerging economies is the speculative demand for commodity futures by financial buyers seeking to hedge potential US dollar and Euro currency weaknesses from excessive monetary stimulation and negative real interest rates. According to the Commodity Futures Trading Commission, speculative demand (as opposed to commercial hedging demand by food and other manufacturers) for commodity futures has increased since 2008 by 40-80% in agricultural futures and other commodities and is now more than 60% of all open agricultural contracts (more than crude oil). Speculative demand for wheat futures is now about one half of all open contracts.
US manufacturers can and do engage in non-speculative hedging of their own operational and pricing risks stemming from commodity price uncertainty. Unfortunately, their hedging costs escalate more than they should from consumer demand alone. Manufacturers' hedging costs are increased by the speculative financial demand for commodity futures. Over the next 12 months, hedging wheat price increases with commodity futures is costing 18% as of November 30. Hedging wheat prices from June 2008 through June 2010 would have cost more than 50% cumulatively above the actual increase in wheat prices. Demand for commodity futures contracts has risen from open interest of 13.7 million contracts outstanding per year as of December 30, 2008 to 30.4 million contracts outstanding today as of November 2, 2010. 1
An example of the magnitude and force of intervention might be useful here. If commodity prices are expected to rise by about 10% per year for the next 12 months, manufacturers can hedge some of this risk by "paying" 14% in hedging costs - a significant increase in the price of hedging against cost uncertainty. Clearly, it would be tempting just to take the price uncertainty and skip hedging. For the US manufacturing sector and the US economy as a whole to face these kinds of cost increases and hedging risk premia, much of which could be reduced by countercyclical trading by the Fed, is even more counterproductive because their hedging activity actually feeds additional increases in commodity prices. Instead, the Fed could step in to sell, say $100 billion commodities futures (about one fourth of outstanding agricultural contracts), reduce the speculative demand for commodities, and reduce the hedging costs of US manufacturers until we have all achieved higher employment levels and uncertainties about growth and inflation have stabilized. Otherwise, we will be facing the ugliest of outlooks in the US: High inflation and high unemployment. Stagflation is a very difficult scenario in which to manage monetary, fiscal, employment, trade, and political tensions.
Incidentally, I would accept the counter argument that perhaps less rather than more intervention, even if implemented wisely, might be the lesser of these evils, but an intelligent and nuanced approach to quantitative easing might be more efficient in meeting both inflation and employment targets over the next 24 months.
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1 CFTC Commitment of Traders Report
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