Simple Monetary Inflation and the Decline in the Dollar Account for a lot of the Rise in Commodities

"Gold futures surged to a record $958.40 an ounce as a slumping dollar and soaring commodity costs boosted the appeal of the precious metal as an inflation hedge. Silver rose to the highest since 1980," reports Bloomberg.

"Investment money poured into commodities overnight, boosting copper and aluminium to 21-month highs while zinc jumped 6 per cent," reports Reuters. "Aluminium firmed $US62 to $US2946, after having touched an intraday high of $US2970 - the highest since mid-May 2006... Copper for delivery in three months on the London Metal Exchange touched $US8,445 a tonne, its highest since May 24 2006, before closing up 3.4 per cent at $US8430 from yesterday's close of $US8150."

What do the commodity markets know that we don't? Maybe they are simply confirming what we've seen signs of all this year: central banks are losing the war against inflation. Oil came slightly off the boil, closing below $100.

Bernanke and company may have targeted their rate-cut fire on financial stocks, hoping to arrest a recession in the U.S. and collapsing financial stocks. But consumer price inflation in the U.S. was up 4.4% year-over-year in January, according to American figures released yesterday.

"Inflation is screaming," says Leonard Kaplan, who runs Prospector Asset Management in Evanston, Illinois. "Lowering rates is only going to make inflation worse and force people into commodities. The funds are piling into gold." It's not just in the States, either.

"French Jan inflation highest in at least 11 years," reports the Guardian. "Nigerian inflation rate increases to 8.6% in January." "Kuwait raises salaries to meet soaring inflation." "Sensible is out, inflation insanity rules," says the Asia Times Online.

There are two factors at work. First is money supply. With the Fed cutting rates, other central banks whose currencies are pegged to the dollar must cut too. Many of the Gulf States have dollar pegs. And China, of course, has a dollar peg. When the Fed cuts, these countries must expand the money supply to keep inflationary pace. Wages and prices rise.

The second factor is on the demand side. Simple monetary inflation and the decline in the dollar account for a lot of the rise in commodities. The growing global demand for scarce resources is the other factor. This explains why 500 grams of butter in New Zealand cost $1.99 last year... and $4.99 this year. Butter isn't so different from oil, at least in the sense that its price is set by global markets.

How tight are global grain markets? Starvation tight. That's how tight. "If you had any major upset where you didn't have a crop in a major growing agricultural region this year, I believe you'd see famine," says William Doyle. Doyle is the CEO of Potash of Saskatchewan, Inc.

You could accuse Doyle of talking his own book. After all, his company makes chemicals to increase crop yields. But his point is a simple one about global consumption and global production. "We keep going to the cupboard without replacing and so there is enormous pressure on agriculture to have a record crop every year... We need to have a record crop in 2008 just to stay even with this very low inventory situation."

Something has to give. Either production has to increase a lot, and quickly (not likely and perhaps not even possible.) Or, consumption must fall. Unfortunately, falling consumption in grains may not be a choice for a lot of very hungry people this year. We'll see.

Locally, famine is the last thing on anyone's mind. The ASX benefited from a generally good reporting day for those companies with half-year and full year results. Telstra, Toll Holdings, and Brambles all reported glowing results. Telstra-that lovable local virtual monopoly-reported a 13% increase in net profit to $1.9 billion on a 6.2% increase in revenues to $12.4 billion. That said, our broadband speeds at home continue to under-deliver.

Here's something to keep you awake at night over the weekend. How much new capital will banks need if they bring their off-balance sheet special investment vehicles (SIVs) back on? That is a huge question hovering over the value of financial stocks. The answer determines how quickly the financial sector can recover from the current subprime flu.

Australian analyst Satyajit Das reckons banks will be forced to take US$1.5 trillion in questionable assets back on to the balance sheet. Under international banking standards (Basel II it's called) banks are required to have 8-10% in equity capital as a percentage of total loans outstanding.

That means if the banks are required to bring bad loans back on the books, they have to increase their capital too. By how much? Das reckons global banks may need to tap the markets for at least $250 billion in new capital in the coming year, and maybe as much as $400 billion, just to meet Basel II minimum capital reserve requirements.

So... where do you think that money is going to come from? Hedge funds? Sovereign wealth funds? Who will be willing to reinvest in the world's banks to that degree? Anyone? Bueller? Hmmn. And if it doesn't happen, guess what will happen to the banks? Do you still think the crisis is over?

One possible and MASSIVELY inflationary "get out of jail card" for the banks is a nationalisation of bad debts. That is, central banks might buy the bad loans (at a discount) to keep the banks solvent and the financial system functioning.

The Fed, for example, can ad anything to its balance sheet it likes. Houses, mortgage backed securities, cattle ranches, gold mines. You name it. It simply creates new money and buys the assets and slaps them on the national balance sheet. Socializing the losses is good for the banks and their shareholders... not so good for taxpayers.

In theory, then, the Fed, the ECB, the Bank of England or the Bank of Japan can all buy the worst-performing asset-backed securities from the banks, you know... the ones that aren't trading and for which there is currently no market price. The catch for investors is that central banks will have to create new money to make the transaction. That's where the massive inflation comes in.

Would the bank stocks be a buy if the government intervened? Would the U.S. dollar survive the loss of confidence in the financial system? And how much higher would commodity prices go if such a solution came to pass? Gold $2,000? More on this over the weekend. Watch your mailbox.

Dan Denning
The Daily Reckoning Australia

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