A fly on the wall at the Fed meetings

We’re observing the extent to which monetary policy is globally connected not just to other central banks, but also to specific markets like commodities and currency. If I were a fly on the wall at the latest FOMC meeting, I may have observed some concern for two very important components that the Fed isn’t really talking about publicly: the strength of the dollar and the effect of a rate increase on commodities—a double-edged sword slashing through the Fed’s inflation target of 2% “over the medium term.”

Why the concern? Dollar strength is a major component towards weakness in commodities, and weakness in commodities suppresses inflation. You can see the extent of this effect from the chart below. It shows the CPI following quarterly moves in crude spot prices.

After 2000, this connection became even more pronounced. The average monthly change in the CPI following a quarterly decrease in crude prices produced little to no inflation. We use quarterly crude price performance to determine the effect on inflation because there’s a time lag for commodity price fluctuations to seep through the economy. It doesn’t just happen.

It’s important to note that crude isn’t the only commodity to have fallen off the cliff. Natural gas, grains, metals, and softs (sugar, coffee) too have declined. We’re now seeing the effect on the meats market, as meats have considerably backed off from their peak prices in 2014. It’s no coincidence that commodities drastically legged down specifically in July 2014, just as the US dollar began to take off. Don’t underestimate the Fed. They noticed too.

If commodities don’t rebound, the Fed can’t act

If the Fed raises rates sooner rather than later, given the strength of the US economy relative to Europe and Asia, it could send the dollar even higher and send commodities even lower, prolonging the horizon of the Fed’s inflation target from the “medium term” to “forever.” At the same time, the Fed needs to protect the economy from the formation of asset bubbles. Some aspects of finance-driven transactions—such as M&A and, to some extent, real estate—have taken on the semblance of froth, at least according to some observers.

Trading against other Central Banks, it’s come to this

Plus, the Fed must have discussed internally the troubles that the ECB (European Central Bank) is facing and needs to assess the effect of a stronger dollar on its progress, or lack thereof. It even added the phrase “international developments” in describing the factors that will go into making a rate hike decision. Make no mistake: central banks are the big traders in the room, and they trade products like deflation, working hard to export deflation overseas whenever they can.

As we mentioned in our previous Chronicles newsletter, Europe is going through a “Japanization” of its markets. This delicate dance that the Fed is facing causes them to “check” at the poker table—or, as they describe it, use “patience.” This isn’t a critique but an acknowledgement that there’s little the Fed can do, and the Fed knows it. Its ace in the hole is its perceived ability to keep a finger on the pulse of developing asset bubbles through its presence in almost every Wall Street bank.

Will commodities revert? The Fed sure hopes so

If the recent commodity rebound has legs, we can see the Fed act sooner rather than later on a rate increase. At least a balancing out of prices to acceptable levels would be enough, which would fit nicely with continued strong job growth. Last week, we saw BP (BP) announce a pullback in its capex budget, a confirmation for many observers that energy may have dropped too hard, too fast, prompting E&P budgets to shut down. Many of the E&P pro formas for new projects had oil prices penciled in above 70 in their top-line assumptions. The Fed may also be concerned that these recent developments could counteract the trend in decreasing unemployment. Less capex, fewer new projects. Fewer new projects, fewer new jobs.

More like oscillation than a full V-shaped reversion

Commodity prices aren’t simple to predict. It’s never just one linear relationship. Everyone knew that the US would approach 10 mbd at the beginning of 2014. Yet WTI prices rose above 106 per barrel. It was only when the dollar started to rise that it set off the initial spark of rapid descent in combination with the ramp-up in production. We saw the forward curve change from backwardation to contango, with sellers bidding up storage.

But oil is the major input of our economy, and at some point, oil consumers will find prices suitable to lock in. If they so much as smell a bottom—especially with confirmation from major players in the industry shutting down their multi-billion dollar projects—they’ll be bidding up those prices in a hurry.

Last week, we saw another print from the DOE (Department of Energy) indicating an increase in inventories. Initially, oil sold off 9%. Let me repeat that: 9%. But the next day, it rebounded and surpassed the sell-off. Simply saying “it’s short covering” is an incomplete and lazy approach. Beware of the lazy approach. If prices rise into the 60s, physical inventories will dump right back onto the market, as producers will be eager to sell their increasing supply. This is what creates oscillation in markets—the hardest thing to predict because it’s never linear.