COMMODITY PRICES--A TEMPORARY SITUATION

Many a blogger has recently started a thread or two in regard to inflation; a very important topic. A lot of confusion exists about the current inflation rate. China, India and other developing nations are bidding up the prices of materials. The bidders add much relative value by processing the materials with low cost labor. They then offer the finished products to consumers. Because the bidders are the low cost producers, consumers happily buy. The goods are being sold at prices that help the bidders improve their standard of living and yet the consumers get to buy goods at low costs. This is a win-win situation.

Good points have been made at BlogginWallStreet.com. The following is a copy of my response to a number of issues.

Jack Miller said...

Commodity prices always go up in the early phase of a strong economic cycle; the CRB spiked in the early to mid 1990's, new production was ramped up and prices came down. The stock market went up for several years after the peaks in commodity prices.

There is only a temporary shortage of copper, iron ore or crude oil, but, you don't get more by flipping a switch. Demand in developing nations is relatively huge. Developing nations now use in total almost as much oil as the developed nations. China produces only 3 million barrels of oil per day and is suddenly having to import 6 million barrels per day. When a huge country grows its GDP by an average of 10% for ten years, you better believe the demand for oil will have grown.

It takes a long time to develop a new mine or oil well. After an expansion in the world wide economy, the first new wells or mines do not add to the net supply because the growth in demand is faster than the growth of supply. Gradually the rate of demand growth slows and supplies gradually catch up. Until it does, increasing prices cause conservation efforts but these also take time. The 40 horse-power Smart Car, not much bigger than a golf cart, is sold out at inflated prices while GM offers $17,000 rebates on full-sized Cadillacs; GM is finding few takers.

The first step toward rationalizing supply and demand is for suppliers to believe that expansion is wise. They have to be sure because it makes no sense to build a 100 million dollar mine only to find prices below the cost of production by the time the mine is ready to produce.

Just like interstate highways. These highways are both the most "profitable" and the most expensive for the governments. A few years ago, a game of political football was played over the 28 mile stretch of interstate quality highway needed for Myrtle Beach SC. Eventually the road was built at a cost of 400 million dollars. It will eventually pay for itself many times over. However, it costs 2 million dollars a year in new gasoline taxes just to pay the interest. The vacation travel economy is very strong but it would have been almost as strong with or without the new highway. The costs of these highways are so large that you normally see significant bottle-necks before a new highway is built.

What company is going to build a 100 million dollar copper mine on speculation that the price of copper might go up? How long does it take to build a coal fired electricity plant? Also, remember that after adjusting for inflation, the prices of commodities go down.

We constantly invent ways to use less material or to substitute cheaper materials. The walls of homes have been improved in many ways but the amount of wood in my den is a fraction of the wood in my parents den and a smaller fraction of the wood in my grandparents' homes. Only a few years ago, all phone calls traveled on copper wire. Then Corning learned how to process sand correctly to carry a thousand times the volume. The cost of transmitting voice and data over fibre-optic cable is a fraction of the costs of copper lines and there is an endless supply of sand on the earth.

The State of S.C. saved over 100 million dollars on the construction of the 28 miles by using modern construction techniques. Millions of Americans are moving to coastal communities to live because they work from their homes over the internet. If you can work anywhere, why not work at the beach. A significantly larger percentage of those who commute via the internet are happier with their jobs. These commuters spend less on food, gas and more.

Inflation rates have been on a downward trend since the late 1970's. Interest rates have been on a downward trend since the early 1980's. The trend is your friend; learn not to fight it. After adjusting for the substitution effect, the average price of the average good purchased in America by the average consumer went up 1.6% last year. The bond market supports the concept that inflation is going lower. The ten year treasury yield is about 4.3% even though the economy grew at 4% last year! The last time inflation rates were consistently below 2% was the early 1950's.

It was the congress not the FOMC that opened the doors to world wide trade. The fact that wealthy Americans are choosing to buy at reduced prices from China, should not be blamed on the FOMC. All of us are wealthy relative to the Chinese. No one needs to take the blame anyway. Free trade is a good thing not a bad thing. The Chinese and the Americans have both netted huge benefits from the liberalization of trade.

There is no set limit on the number of commodity contracts; people sell contracts short everyday and only a fraction of total production is normally under contract. The size of US trade with China has only a positive influence on inflation. The unit cost of production in China is lower than here. Prior to the free trade, Americans paid much higher prices for these huge volumes of goods. Inflation is measured as an index of many items.

If a consumer buys $100 worth of items at Wal-Mart, that would have cost $200 without free trade and if the consumer spent an extra $50 on gas, then he would have saved a net of $50. His inflation rate would be negative.

I am typing this response on an extremely powerful computer relative to what was available 5 years ago. A computer with this power would have cost $1,000,000 15 years ago. It cost me $1,200 two years ago and I can replace it tomorrow for only $500. The $500 replacement machine would be so powerful that it would have cost me $5,000 or more two years ago. Indeed, many of the features were not available at any price 15 years ago. Twenty five years ago, long distance telephone calls cost $1.25 per minute in today's dollars. Today long distance calls are free through internet phones.

Stop to smell the roses, low inflation rates are all over the place. The spike in commodity prices is a relatively temporary phenomenon. It is based primarily on supply and demand and has little to do with speculation. Besides, the asset class to buy when there is relatively low inflation is stocks. Buy stocks before the next legg of the bull market gets underway.