Inflation fears and commodity prices Jayati Ghosh

The global recession is still very much with us, despite the recent attempts by media and some policy makers especially in the North to dismiss it as almost over, and to find some indications of the “green shoots” of recovery in almost each item of economic and financial news. But even as the downturn continues to cause trade flows to decline, and jobs to be lost, some analysts are already talking about the fears of a major inflationary spiral once the global economy recovers.

Most of those who are raising this concern are those who were opposed to countercyclical economic policy measures in the first place. When governments in the developed world, and especially in the US, came up relatively rapidly with measures to provide huge bailouts to ease bank lending in the face of the severe credit crunch and lower interest rates, such critics argued that this would release too much liquidity into the system and therefore eventually create inflation.

They were even more opposed to fiscal expansion and running large deficits to combat the liquidity trap conditions that seemed to have emerged in core capitalist economies. They insisted (and some like the German Chancellor Angela Merkel continue to insist) that such a strategy would simply generate more inflation. There was an implicit, usually unstated, concern that the positive effects of fiscal expansion would leak out through imports so that other economies would benefit rather than those in which the fiscal expansion occurs.

There are some obvious flaws to such an argument, which fundamentally indicates a monetarist approach to economic policy. In situations of unemployment and excess capacity, government spending creates new effective demand that then generates more output through a multiplier process. Therefore new demand is met by new supply, and this creates an output response rather than the price response that is expected by monetarists. It is only in conditions of full employment, or where there is some supply bottleneck that prevents the multiplier process from running its course, that any inflation would result. In any case, the spectre facing the world a few months ago was one of generalised deflation, or falling prices, and this still seems to be happening in most major economies. So this argument was misplaced.

However, while the basic premises of the monetarist argument are wrong, this does not mean that the threat of future inflation can be completely discounted. In fact, it can be argued that even without a complete revival of the global economy, and even as wage incomes throughout the world continue to fall, there may be upward pressure on certain prices in the near future. In particular, global commodity prices – especially those of oil and food – may well increase again in the next couple of year.

The reasons for this possibility are very different from those offered by monetarists. They are not even related to possible imbalances between global demand and supply. Instead, they reflect the continuing possibility that financial speculation can cause sharp changes in the prices of commodities in the world market.

Financial deregulation in the early part of the current decade, especially in the US, gave a major boost to the entry of new financial players into the commodity exchanges, and allowed unregulated activity in commodity futures markets, which became a new avenue for speculative activity. The result was excessive volatility displayed by important commodities like oil, minerals, food and other cash crops over 2007 and 2008. As more purely financial players entered these markets in search of quick capital gains, prices in the futures markets soared and drove up spot prices, in a process completely the opposite of the risk-hedging role that futures markets are supposed to play. The subsequent sharp declines in prices were also related to changes in financial markets, in particular the need of financial agents for liquidity to cover losses elsewhere. These price changes did not reflect real demand and supply at all, since both scarcely changed over the year.

In food items, such volatility had very adverse effects on both cultivators and consumers. It sent out confusing, misleading and often completely wrong price signals to farmers that caused over-sowing in some phases and under-cultivation in others. Also, while the pass-through of global prices was extremely high in developing countries in the phase of rising prices, the reverse tendency has not occurred as global prices have fallen. Both cultivators and food consumers lost out because of extreme price instability, and the only gainers were the financial speculators who were able to profit from rapidly changing prices.

The problem is that, despite the unfortunate lessons delivered by the functioning of financial and commodity markets in the past two years, the moves towards more effective regulation are still hesitant and inadequate. Even the recent document released by the Obama administration in the US on financial sector reform does not adequately come to grips with the need to control commodity futures markets and prevent the kind of speculative activity that has caused so much damage.

Meanwhile, it is also the case that banks and other financial players are once again awash with liquidity and looking for profitable avenues to invest in. Commodity markets are once again ripe to be invaded by such players. And prices in such markets can be talked up not only by such investment but also by pliant international financial media. If there are any short term supply reductions in any major grain market, some poor harvests because of adverse weather conditions and so on, the chances are that prices in such markets will rise much more and faster than is warranted by any supply shortfall. This will be because of speculation, but once again it will have very detrimental effects on the real economy, especially in the developing world. And such price rises will then force governments to focus on inflation control rather than real economy revival