Would Rising Commodity Prices Lead to Inflation in the U.S.?

Sources:

WSJ: Fed’s Hoenig: Policy Plays Role in Commodity Price Surge

WSJ: Fed Finds Climbing Costs Hit Shoppers

WSJ: Commodity-Price Gains Dog Bernanke’s Inflation

The Economist: Inflation Lessons from the Asian Crisis

CNN Money: Coming Soon to U.S. Shores: Higher Prices

NYT: Companies Warn That Higher Prices Are Looming

Prices for cotton, wheat, iron ore, steel, wheat, sugar, beef, pork, oil, and many other commodities have been rising since last summer. Fearing that consumers were unlikely to pay higher prices, U.S. retailers and manufacturers have been absorbing these commodity price increases, thus sacrificing their profits, to keep prices steady. Experts claim that U.S. businesses can no longer do so. Companies such as Hanes Brands, Kellogg, and Whirlpool have already announced price increases. Others, including Kraft and Proctor & Gamble, expect to raise prices soon.

There are several reasons for the surge in commodity prices. Political turmoil and supply disruptions are major factors. Another factor is the rapid economic growth in developing countries, which has resulted in dramatic improvements in the quality of life there. Better living standards, in turn, have led to a higher demand for consumer goods, thus increasing the demand for commodities. Since the supply of raw materials has not kept up with demand, commodity prices have risen.

In addition to these external factors, some experts, such as Tomas Hoenig, the President of the Federal Reserve Bank of Kansas City, claim that U.S. monetary policy is also to blame for the rise in commodity prices. Mr. Hoenig asserts that domestic monetary policy has a global impact. According to him, the U.S. Federal Reserve must increase interest rates to prevent inflation. Other experts believe that to stave off inflation the Federal Reserve must also immediately end its $600 billion bond-buying program scheduled to wind down this summer.

During his recent semi-annual congressional report Mr. Ben Bernanke, the Chairman of the Federal Reserve, denied that U.S. monetary policy had any role in the surge in commodity prices. He also emphasized that rising commodity prices can cause inflation only if they lead to higher wages. When consumers experience or expect inflation, they are likely to demand higher wages. Higher wages lead to higher production costs and exert a further upward pressure on prices. Thus, rising prices would cause wage increases and vice-versa. This cycle, known as the wage-price spiral, continues until inflation “spirals” out of control.

Despite the recent surge in commodity prices, statistics support Mr. Bernanke’s skepticism regarding the threat of inflation. In December 2010, the annual inflation was 1.4 percent, and economists do not expect inflation to rise above 2.5 percent in 2011. Mr. Bernanke opines that inflation fears are unfounded for at least two reasons. First, with unemployment rates hovering around 9 percent, it is doubtful that consumers would be able to command higher wages. Second, since the price of raw materials represents a small share of the cost of consumer goods, passing the increase in commodity prices to consumers is unlikely to significantly increase the price of end products. Indeed, most experts agree that wages, and not commodity prices, are the bigger driver of inflation in the U.S. Therefore, higher commodity prices appear unlikely to lead to inflation.

Although inflation is of no real concern at this time, Mr. Bernanke has alluded to some of the other negative implications of rising commodity prices. For example, he fears that the increase in prices of raw materials may stifle economic growth by draining consumers’ purchasing power. Slower economic growth would, of course, significantly prolong the U.S. economy’s recovery.