Could higher commodity prices be deflationary?

With oil prices rising from geopolitical risks in the Middle East and with supply shocks in many commodity prices still upon us, we have to ask the question of whether the price gains are related to inflationary expectations or just supply imbalances.

The supply imbalance story especially for oil would suggest that the higher prices will negatively affect consumer balance sheets and production costs. In this case, economic growth would slow and the net effect would be for another recession. This could lead to lower core inflation rates or deflation.

The inflationary expectations story is that commodity prices will gain because excess cash is used to buy commodities as a store of value. At low interest rates, the cost of holding commodities is low. Clearly, index interest suggests that commodity demand is on the rise, but the pass-through to the economy is more uncertain.

The problem for central bankers is trying to separate what is going on with prices. This is not easy and makes the chance for overshooting greater.

Note the following views.

David Rosenberg:

It is also interesting to see how government bond markets are reacting to the oil price surge — by rallying, not selling off. In other words, bond market investors are treating this latest series of events overseas as a deflationary shock

Ambrose Evans-Pritchard:

The classic theory by Rotemberg and Woodford (1996) is that a 1pc rise in crude prices cuts 0.25pc off US output over six quarters or so. If they are anywhere near correct – and the “energy intensity” of the US economy has diminished over time – the sort of 40pc rise since last summer rise will indeed have a severe effect. Subsequent scholarship suggests this is too extreme, unless central banks behave like idiots.