Cross-references
Just about every economic indicator says something about demand pressures. Capacity use and unemployment are particularly useful, as are indicators of the government’s monetary and fiscal stance. See also Balance of payments and, particularly, Exchange rates (Chapters 10 and 11).
Rates of change
Remember to distinguish between a fall in the level of prices and a fall in the rate of increase. If the inflation rate declines but remains positive, prices are still rising.
As a rule of thumb, annual inflation of 0–3% is considered good. Double-digit percentage rises are definitely bad news. Negative inflation, although rarely experienced, is notgood either since it signals deflation and – almost certainly – a contracting economy.
Gold price
Measures: Market price of gold.
Significance: Raw material and psychologically important store of wealth.
Presented as: $ per oz.
Focus on: Trends.
Yardstick: Average London spot prices were $294 in 1998, $364 in 2003 and $872 in 2008. In 2009 the price reached over $1,000.
Released: Continuously round the clock.
Influences on the price of gold
The gold price reflects the interaction of supply and demand in a global market with many buyers and sellers and a free flow of information. Supply depends on production and sales from stocks while demand is influenced by gold’s dual function as an industrial raw material and the ultimate store of wealth. It provides a security which cannot always be matched by paper money. Speculative demand is the major short-term determinant of price.
Supply
In 2007, China overtook South Africa to become the world’s largest gold producer. It maintained that position in 2008, while the United States pushed past South Africa and Australia to become the second-largest producer. Russia and Peru were not far behind. Other countries’ production generally edges upwards in the long run in response to higher prices. Sales of gold from stocks are important since stocks are many times greater than annual production. Even though central banks and the IMF sold gold from the 1970s to the 1990s when it fell from favour as a monetary standard, they still hold close to 1 billion oz in their vaults. Uncertainty about what they might do with this may depress prices; and the gold price fell sharply in 1999 after the British government said it planned to sell some of its gold. However, central bankers in developing countries will dent their gold hoards and egos only as a last resort.
Demand
Fabrication demand is mainly for jewellery, electronics and dentistry. Jewellerydemand accounts for over three-quarters of industrial and commercial use and is sensitive to price. Electronics demand reflects the fortunes of the industry, decreasing during recession. Use in dentistry is fairly constant, if vulnerable to replacement by man-made materials.
Speculative and investment demand is much harder to predict since flows are large in relation to stocks and output. There tend to be flights into gold which push up its price during rapid inflation, exchange-rate turbulence or political instability worldwide. However, these are less marked now that financial markets offer more sophisticated hedging instruments. Indeed, gold-backed financial instruments, such as gold options, have eroded the lure of holding the metal itself.
Forward sales
Financial engineers have also created a wide range of instruments which allow producers to hedge several years’ future output. This was probably the most important influence on prices in 1990. Every time prices rose, they were capped as forward sales pushed more metal into the world market. According to market analysts’ GFMS, forward sales increased through the 1990s, peaking in 1999 at 3,080 tonnes of gold. This had fallen to 333 tonnes at the end of 2008.
Currency
Since gold is generally priced in dollars it is important to distinguish between exchange-rate effects and underlying price movements. The easiest way to do this is to convert the price into a basket currency such as the SDR. Surprisingly, not many people do this.
Gold as an indicator of inflation
Many economists, especially Americans, argue that gold is a useful indicator of inflationary pressures, but it is difficult to disentangle all the influences on gold prices. Baskets of commodity prices probably make better leading indicators than gold alone. Moreover, it does not make much difference whether gold is included or excluded from such baskets if they are weighted according to world production levels. If gold is given a greater weight to reflect its psychological importance, the predictive value of such baskets deteriorates. In other words, a commodity price index is preferable as a leading indicator of inflation.
Oil prices
Measures: Market price of crude petroleum.
Significance: Major energy source essential to every economy; also a chemical feedstock.
Presented as: $ per barrel.
Focus on: Traded crude such as North Sea Brent or West Texas Intermediate.
Yardstick: In 1990 the oil price was around $20 a barrel. In 1999 it dipped to around $10 a barrel before recovering to $25 a barrel before the end of the year. In 2005 it reached $60 dollars a barrel and topped $75 a barrel in 2006. After a brief fall during 2007, it climbed up to $145 in mid-2008, only to fall abruptly to $30 by the end of the year. In 2009 it rose to nearly $80.
Released: Continuously round the clock.
Prices, supply and demand
Oil prices are sensitive to supply and demand, with OPEC exports being the major determinant of short-term price fluctuations.
Demand
There are obvious seasonal variations in oil demand; consumption always decreases during the hot summer months. However, in the short term annual demand is fixed in relation to GDP. Consumption fluctuates with the economic cycle in industrialised countries and rises relentlessly in line with economic growth in less developed countries. (Since 1973 oil intensity – oil consumption per unit of GDP – has fallen owing to conservation and the substitution of other fuels.)
Supply
Oil producers can be divided into three groups: OPEC, the former communist bloc and what the oil industry has traditionally called the free world. Oil output in the free world is price-responsive; it becomes profitable to extract oil from marginal fields only when prices are high. Within such considerations the free world normally produces oil flat out. The gap between demand and supply is therefore filled by OPEC crude. The organisation’s attempts to control the world petroleum markets led to oil price rises in 1973 and 1979 and a sharp slump in 1986. In the past, world market sales from producers in the former Eastern bloc did not fluctuate wildly, but are now rising annually.
In the short term OPEC exports reflect the balance between members’ collective willingness to restrict output to try to control the world oil market, their individual need for revenue and the general political situation in the oil-producing countries. More ominously for the longer term, OPEC members are sitting on oil reserves which promise to outlast all other supplies.
Table 13.2 The world oil market
Stocks
Whereas almost all the gold ever produced is still in existence (even if some is in orbit or on the sea bed), oil is rapidly consumed. Oil companies and some governments hold working and strategic stocks which help to prevent prices rocketing in times of temporary crisis, such as during the Iraqi invasion of Kuwait in 1990. Stocks of 100 days’ forward consumption are about the highest to expect.
Traded crude
OPEC’s slippery grip on oil trade means that its official selling prices (OSPs) are not necessarily representative of market pressures. However, whereas nearly all oil was sold on long-term contracts at fixed prices in the past, most is now traded at market prices. Traded crudes such as North Sea Brent blend or West Texas Intermediate are therefore good indicators of market conditions.
Commodity price indices
Measures: Changes in groups of commodity prices.
Significance: Advance warning of inflationary press
ures.
Presented as: Index numbers.
Focus on: Trends.
Yardstick: Prices fluctuate wildly; hope for level trends.
Released: Daily by Reuters; weekly by The Economist; others monthly.
Significance
Commodities are unprocessed or semi-processed raw materials used for foodor in the manufacture of other goods. Commodity prices in generalare important lead indicators of cost pressures. Prices of metals and, to a lesser extent, non-food agriculturals are also indicative of the level of demand in theindustrialisedcountries.
Monetarists note with glee the correlation between high commodity prices and liquidity in the late 1980s, and the monetary contraction and commodity price falls of the early 1990s.
Price instability
Analysis by the World Bank shows that price instability for sugar, the least stable commodity price, is over 11 times greater than that for oranges, the most stable. Moreover, commodity price fluctuations have increased sharply since the 1960s. Quite apart from the eightfold increase in the real price of oil during the 1970s, the prices of other commodities moved sharply. For example, food prices fell while timber prices rose in the 1980s. Many economic problems can be traced to these shocks and the policy responses to them.
13.2 The Economist commodity price indices
Sources: The Economist; Thomson Reuters
Influences on prices
Commodities may be divided into three broad groups depending on whether their prices are influenced mainly by demand, supply, or both.
Demand
The prices of industrial raw materials, suchas metals and minerals, fluctuate in response to changes in demand, reflecting mainly economic conditions in industrialised countries. Recession brings lower demand and weaker prices. Supply tends to be more stable and predictable.
Demand for metals declined as the industrial countries introduced materials-saving technology during the 1970s and 1980s. Between 1990 and 1993, The Economist commodities dollar index for metals fell by over 30 percentage points. By around mid-1994 it had recovered all that lost ground and more, before it dropped in 1995 to slightly below its 1990 level. By November 2001 it had fallen a further 39%. It then turned up, thanks to Chinese demand, and by June 2007 had soared by 284%, only to fall by 58% by March 2009 amid the world economic downturn.
Supply
Food prices are influenced most heavily by unplanned changes in the supply side. For example, world vegetable oil prices depend significantly on the effects of weather on the American soyabean crop and on policies relating to American stockpiles. Food prices fell in the late 1980s and early 1990s as production and stocks recovered from the 1988 drought in America, which cut output and pushed up prices.
Metals
The ups and downs in the prices of industrial metals since the beginning of 2008 have reflected the fluctuating fortunes of the world economy. The copper price, which peaked in April 2008, had fallen by over two-thirds from that high by December 30th last year, when it hit bottom. The price of nickel fell by a whopping 72.3% from peak to trough. Prices have recovered as growth has returned to most rich countries. Copper is now selling for more than it did at the beginning of last year. The price of zinc has doubled from its low point last December, though it is still 2.9% cheaper than it was at the start of 2008. The nickel price has risen by nearly two-thirds in the year to November 24th.
Metals
Source: London Metal Exchange
The Economist, November 26th 2009
Supply and demand
Non-food agricultural products such as cotton and rubber are vulnerable to changes in both supply and demand.
Index composition
Creating an ideal commodity price index is intellectually testing because:
commodities are not comparable – 1 tonne of coffee is quite different from 1 tonne of copper;
they are difficult to value – for example, only 6% of rice production is traded on international markets; and
relative prices are distorted by large fluctuations in individual commodity prices.
Creeping up
Food prices are inching up again
World food prices are 2.2% lower now than they were at the beginning of 2008, according to The Economist’s food-price index, which has fallen by nearly a quarter since its peak in July last year. The price of wheat, which has the largest weight in the index, is now nearly a third below its January 2008 level. Rice prices, which had risen to over two-and-a-half times their level at the beginning of 2008 by the end of April last year, have now fallen to just over half that level. But rice is still nearly one-and-a-half times as expensive as it was at the beginning of 2008. A steady rise in the price of sugar over the past month means that it is now more expensive than it has been at any point since the beginning of last year.
Food prices
The Economist, May 29th 2009
Despite these problems there are many indices combining the prices of several commodities. Apart from The Economist commodities price index, the most widely followed indices are prepared by the IMF, the UN, the World Bank and the American Commodity Re search Bureau (CRB). They differ in three main ways.
The basket contents
The Economist index includes only commodities which are freely traded on open markets. This excludes items such as iron ore which has a big weight in the other main indices. The Economist also omits oil and precious metals such as gold. The two previous briefs suggest that gold and oil are important commodities but they are subject to special factors which may make them less valuable as simple cost indicators.
The basket weights
The Economist index is designed to measure cost pressures in industrial countries; its constituents are weighted according to their share in world imports. The UN, IMF and World Bank indicators are intended to monitor the terms of trade in developing countries; the constituents are weighted to reflect shares in developing countries’ exports. The CRB index just gives equal weight to all components, which understates the importance of industrial commodities and so makes it less useful as a leading indicator of inflation.
The currency
Commodity prices are most often quoted in dollars. As a result, currency fluctuations will move indices even when there is no underlying change in commodity prices.
Bottom line
The Economist index is hard to beat for tracking the interrelation between cost pressures and inflation; see the weekly table in The Economist. A rise in the index may signal higher inflation, but the final outcome depends on monetary conditions and supply and demand in other factor markets such as labour.
A UN, IMF or World Bank index should be used if you are interested in the way that changes in commodity prices affect the external balances of developing countries: a fall in commodity prices implies a deterioration in exporters’ trade balances.
Export and import prices; unit values
Measures: Prices of traded goods.
Significance: Helps identify cost pressures, potential exchange-rate problems and changes in competitiveness.
Presented as: Index numbers.
Focus on: Changes in unit values (see text).
Yardstick: A positive rate of increase, as close to zero as possible, is good. Check the ratio between import and export prices (see Terms of trade, page 172).
Released: Monthly with trade figures; quarterly with GDP.
Prices
Import or export price indices, including the deflators released with GDP data, capture changes in both the prices and the composition of a country’s external trade.
Unit values
Indices of import or export unit values, which are essentially fixed-weight price indices, highlight changes in prices only. This is useful for reviewing cost and competitive pressures. However, since the weights get out of date when the structure of trade changes – as it inevitably does – unit value indices are best for analysing short-term trends.
Export prices or va
lues
Compare export price indices with domestic price indicators, such as the producer price index for home-produced goods, to get a feel for the way that manufacturers are passing on cost pressures to foreign buyers; or perhaps being constrained from doing so by international competitive pressures.
Import prices or values
Use import price indices to judge external cost pressures. Import prices that are rising faster than domestic prices are a clear warning of imported inflation.
Erratic items
Prices of raw materials can fluctuate widely. It is often sensible to look at price indices which exclude these more erratic items to identify underlying pressures.
Terms of trade
One of the most useful ways of looking at import and export prices is by examining the ratio between them, which is known as the terms of trade (see page 172).
Producer and wholesale prices
Measures: Prices of goods at the factory gate.
Significance: Leading indicator of cost pressures.
Presented as: Monthly index numbers.
Focus on: Percentage changes.
Yardstick: OECD average producer prices rose 3.5% during the period 1990–98 and 3.4% a year during the period 2000–08.
Released: Monthly, at least one month in arrears.
Wholesale price indices
(WPIs) cover prices charged at the first stage of bulk distribution and generally include import prices. WPIs were first introduced to measure prices of raw materials.
Producer price indices
(PPIs) track prices of home-produced goods at the factory gate. Most PPIs cover output prices of goods, although some countries also prepare input price indices for raw materials purchased by industry. In principle, input prices include transport to the factory and output prices are ex-works, although such prices cannot always be identified neatly.
PPIs shed light on cost pressures affecting domestic production and are more useful than WPIs. Most major countries now produce PPIs. The indices cover manufacturing and, sometimes, construction.
Guide to Economic Indicators Page 18