Wednesday, December 22, 2010

How Inflation Creates Commodity Mini-Cycles

As Jim Rogers persuasively argued in his book Hot Commodities, most commodity prices goes through long super cycles because commodities have a low short term price elasticity of supply and demand., while having a lot higher long term price elasticity of supply and demand.
If there is a big increase in demand (or decrease in supply), supply (from new sources) can increase only slightly in the short term because it takes a lot of time both for natural reasons and political (environmentalist, bureaucratic etc.) reasons to find more of for example oil and metals, and even when new resources are found, new obstacles of both natural and political nature prevents them from being actually extracted.

As a result, the increase in demand from some or decrease in supply must in the short term be met by a decrease in demand (from others) through higher prices.

Moreover, the required short term price adjustment is further elevated because most people find it too difficult or expensive to adjust in the short term. If they have an SUV and gas prices go through the roof, they still might not switch to a hybrid car because the switch would be very expensive.

For these reasons, sudden increases in demand or decreases in supply will cause dramatic short term price increases and these increases will usually stay for a while.

However, after several years, new wells or mines will be found and after several more years, commodities will be extracted from them. As a result, supply will start to significantly increase. Moreover, after several years with elevated prices, people will have been able to reduce their use or perhaps even entirely substituted it. As a result, demand will significantly decrease.

As a result of the increase in supply and decrease in demand, a dramatic price decline will occurr. This will cause a new period of low prices, because supply and demand also responds slowly in the short term to low prices.

I agree fully with the above described analysis, but as I wrote in my review of Rogers book I felt it was incomplete because it left out how inflation affected commodity prices. Both because commodity prices, being traded on markets, are more flexible than others and also because commodities are very far from the final consumers (and thus in accordance to Austrian theory making them extra sensitive to real interest rate changes) and also because of the above mentioned low short term elasticity of both demand and supply, inflationary policies will raise commodity prices a lot more than consumer prices in general.

One answer as to why Rogers left it out suggested by an Austrian leaning friend of mine is that Rogers felt that he was only interested in the long term super cycles created by the analysis he described, and wasn't interested in the more medium term effects caused by inflation. And it seems unlikely that inflationary policies will affect the two decade or so long cycles that Rogers described as they have little affect omn the long term fundamentals.

And that is probably correct. But while Rogers wasn't interested in it, it should be interesting to anyone who thinks that price fluctuations on a shorter term than two decades or so are relevant. The three reasons I described is in fact why inflationary policies will create mini-cycles over a few years.

Because inflationary policies have little or no effect on the long term fundamentals of commodity prices relative to other prices, while having strong positive (in the sense of increasing) effects on commodity prices in the short term it follows that whenever central banks starts to pursue more inflationary policies, commodities and other assets that benefits from higher commodity prices are good investments. However, as this also means that commodity prices will fall later, investors should when it looks like the inflationary policies will have to be ended or reversed should go short on such assets