Commodity boom backfires on consumers


By Michael Mackenzie
Financial Times, London
Friday, February 29, 2008

The Federal Reserve is attempting to fill up the liquidity punchbowl with big interest rate cuts. But it is beginning to look like an old party trick. Cheap cash for consumers and Wall Street banks has not translated into lower mortgage rates, let alone alleviated stress in the credit market.

Instead the prime beneficiary has been commodities. The dollar has fallen out of favour and set record lows against the euro and a basket of rivals, helping to boost commodities prices across the board.

Since the Fed started to cut rates last September, the Reuters/Jefferies commodity price index has risen more than 30 per cent, with oil, precious metals, and wheat all setting record prices this week.

As a result the beleaguered US consumer faces a creeping tax in the form of higher petrol and food prices, on top of negative wealth effects from housing and the stock market's slide since October. If this trend continues, consumers may get little relief from rebate cheques due in the summer as part of the government's fiscal stimulus plan.

The real sting, however, from higher commodity prices and a weaker dollar comes in the form of higher inflation expectations. In the past month the yield on long-dated Treasury bond yields has risen sharply and the deteriorating mortgage market has pushed home loan rates back to where they were last September.

In other words, the 2.25 percentage point cut in the Fed funds rate in this period has not sparked the kind of mortgage refinancing boom that slashed home loan costs for consumers earlier this decade.

When the Fed sharply lowered interest rates between 2001 and 2003, problems caused by the technology bust were alleviated as easy money pumped up the value of real estate and ultimately fuelled a bubble in credit.

Now, a year after subprime mortgages emerged as toxic waste in many investment portfolios, banks and homeowners share a problem. Both need to shore up reserves of cash -- whether through capital or savings rates -- as many areas of the financial market remain dysfunctional and home prices keep falling.

No surprise then that Ben Bernanke, Fed chairman, told members of Congress this week that in spite of "some similarities" with 2001, "both fiscal and monetary policy" faced additional constraints.

"The effects of the stock market decline in 2001 were primarily on investment firms and not on consumers," Mr Bernanke said. "Now consumers are taking the brunt."

Higher commodity prices were also causing "inflationary stress" and complicating the Fed's efforts in countering the slide in the economy.

That will not stop the Fed cutting rates further, because an easier monetary policy is the central bank's major tool. Its hope is that helping the banking system via a steeper yield curve -- which should make lending for the long term more profitable -- will eventually resurrect the credit system. But such a process takes time.

The edge of rate cuts is clearly blunter now that the links in the global economy are more pronounced than they were earlier this decade. More rate cuts weigh on the dollar. They also sharpen the appeal of owning commodities that are a bet on faster growth outside the US and a hedge against inflation.

This week the California Public Employees Retirement System, the largest US pension fund, announced it would put more of its money into commodities, illustrating that they are increasingly seen as a viable asset class by investors.

As the funds rate falls, it is no surprise that money is flowing into commodities and not equities, or for that matter arcane parts of the fixed-income market, which are still being shunned.

Meanwhile, the prospect of a hard landing for the US economy grows as the commodity boom blows back on the consumer with higher prices for essential goods.

Therein lies a harsh reality for the Fed. An extended slowdown or recession in the US will eventually sap global growth as US consumers rebuild their savings and in so doing place a floor under the dollar, break the commodity boom and arrest rising inflation.

This time it appears a hangover cannot be avoided by simply refilling the punchbowl.

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