Central Banks to the rescue - Outside View by Asad Dossani

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Central Banks to the rescue
Jan 18, 2011

In recent weeks and months, there has been a general increase in commodity prices. The rise in prices of agricultural and energy commodities has been sustained and is starting to have adverse effects. Food price inflation especially affects poorer people for whom food expenditure makes up a significant portion of their total consumption. The last time that food prices reached these levels in 2008, many countries saw riots.

Brent crude oil nearly reached USD 100/barrel last week. Energy price increases tend to affect the entire economy. Costs of production go up for businesses - thus reducing profitability and future investment. This in turn has a negative impact on total employment and national income. Finally, consumers themselves will suffer from higher utility and transport bills.

The way in which a society suffers from rising commodity prices is inflation. Increased prices of food and raw materials increase the price of everything else too. Our incomes dont grow at the same rate, so we become worse off. Like when anything else in the economy goes wrong - central banks come to the rescue.

Central banks of many countries are concerned about rising inflation due to increased commodity prices. They want to do something about it - they want to stop this inflation from occurring. Is this possible? Central banks have control over their own money supply through the use of the interest rate. Increasing the interest rate reduces borrowing and investment, and consequently inflation.

Excess inflation primarily occurs for two reasons. The first is when money supply is increasing too quickly. Increasing amounts of money chasing the same number of goods leads to higher prices - and this is the type of inflation the central bank can and should prevent through higher interest rates.

Inflation can also be caused by supply and demand factors. Oil prices will increase because of high growth in emerging economies. Food prices will increase because of poor harvests due to bad weather. These are real factors that have nothing to do with nominal (money supply) factors.

If a central bank tries to raise interest rates in response to commodity price inflation, it will not work. In fact, it will only make things worse. The only way to have lower food prices is if we produce more food. The only way to have lower energy costs is to become less reliant on oil and find alternatives. Both of these objectives require long-term investments in better technology. Raising an interest rate does not achieve this.

If central banks do raise rates, the likely effect will be reduced economic activity - which may in turn lead to lower commodity prices (due to lower demand), but does make everyone worse off overall. It is important for countries and governments around the world to recognize that there is no quick fix for commodity price inflation, and the only solution is long-term.

Disclosure: I do not hold the currency/commodity viewed/opined in this column

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

Disclaimer:

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