Crisis and recovery collide
The Global Price Index of All Commodities has more than doubled since its pandemic low in 2Q2020, pushing 62% higher than its average during the last business cycle. COVID-19’s dislocations are responsible for much of this run-up.
- The global economy reopened unevenly from the pandemic; some suppliers remained shuttered as demand rapidly rebounded. Transportation bottlenecks are also crimping the flow of raw materials.
- Changing consumer habits are creating unprecedented demand for finished goods.
At the same time, Russia’s invasion of Ukraine is roiling the market for many crucial commodities. Russia supplies 10% of the world’s oil and is a major exporter of metals like palladium and nickel. And Russia and Ukraine together account for approximately a quarter of the world’s wheat exports.
- Even if peace is reached in Ukraine, markets are likely to price in political risks for these commodities. Futures markets anticipate oil prices to remain elevated for years.
Fuel for inflation
Consumers are pretty insulated from the rising price of many raw materials, because materials compose a relatively small fraction of the cost of most finished goods. Plus, manufacturers purchase raw materials through long-term futures contracts, shielding consumer prices from market volatility.
- Example 1: A men’s dress shirt requires less than a dollar’s worth of cotton to produce.
- Example 2: The average car contains about $1,000 of metals. A doubling of metals prices might raise the vehicle’s production cost by about 3% of MSRP.
But energy is a different story. Consumers are already feeling higher energy costs, because rising oil prices almost immediately translate into higher prices at the pump.
- For every $42 rise in the price of a barrel of crude oil, the average household will spend an extra $500 annually on gasoline.
- Over time, electric vehicles may decouple transportation costs from oil prices. But in the near term, most commuters are locked into paying higher prices for fuel.
Two historic commodities crunches show that the impact of rising raw material costs is not straightforward.
In the 1970s, the OPEC oil embargo sent energy prices skyrocketing, leading to a prolonged period of slow growth and high inflation in the U.S.
In the early 2000s, China’s rapid industrialization created a prolonged rise in the price of metals, agricultural goods and energy products. But the higher cost of raw materials was offset by the expanding productive capacity of Chinese manufacturers.
- For consumers, rising commodities prices were largely masked at the retail level by the new availability of inexpensive imported goods.
- For businesses, global trade brought higher profit margins and renewed investments in productivity-enhancing technologies, which contributed to disinflationary pressure.
Past the commodities crunch
The present situation is different from past episodes in important ways—and the policy response will be challenging. But there are still economic trends we can follow.
- The American economy is far more dynamic and far less oil-intensive than it was 50 years ago. But the geopolitical risks driving up prices now are not creating new productive capacity globally.
- Pandemic-era pressure on commodities should soon ease as shipping bottlenecks subside.
- Other commodity prices could remain high for years, until new mines and oil wells come into production. For businesses that are highly dependent on the cost of raw materials and transportation, this could be a challenging stretch.
For most businesses, the ultimate impact of the commodities spike will depend on the Federal Reserve’s response.
- Currently, the Fed anticipates moving to a neutral monetary stance, raising interest rates to somewhere between 2% and 3% and shedding assets purchased during the pandemic. This will end the excess demand from artificially low borrowing costs.
- For businesses, a neutral policy is good. The economy is running near full capacity, and profits are at record levels.
- There’s no sign the Fed sees the need to raise interest rates into a restrictive posture, which would likely curtail consumption and dampen inflation but hurt economic growth.
What to watch
Keep an eye on whether the rising cost of commodities and oil starts to spill over into core inflation. If it does, high inflation expectations could compel the Fed to plan more interest rate hikes, which could cool the economy.