(snip)"Unprecedented global geopolitical instability will have its most obvious impact on international commodity prices. More frequent energy supply disruptions in the Middle East and Africa, combined with accelerating natural oil production declines in the world’s largest oil fields, will keep crude oil and natural gas prices buoyant. Slower than anticipated global economic growth will not push oil prices lower in 2007.
Production discipline - much greater than generally understood - among the world’s major oil exporters will ensure oil supply growth remains below demand growth. The continued rise of global energy prices in 2007, paired with growing demand for renewable energy, will produce further strong increases in international grain prices. In 2006, corn and wheat prices in the US jumped by 70% and 60% respectively. Much of this jump occurred between September and December.
Rapid growth of ethanol production capacity worldwide has contributed to this leap in corn and wheat prices. Prices for soybeans and other oilseeds have also begun to head higher on the back of rapidly growing global demand for biodiesel fuel. The substantial increase in petroleum-related energy prices since 2001 is only one factor behind growing demand for biofuels. Increasingly stringent environmental regulations, energy security concerns and targeted levels for alternative energy use in many countries is also driving demand for biofuels.
Inflation and recession
The growing use of corn, wheat, soybeans and other grains to produce biofuels is expected to nearly double prices for these commodities in 2007. In addition to grain-related foods, prices for other food staples that are grain-dependent, including meat and milk products, will also head higher in 2007. The result will be much higher than expected US inflation. Consumer price inflation (CPI) in the US is already significantly higher than CPI in Germany, Switzerland, the UK and Japan. In 2007, US inflation will accelerate, widening the inflation gap between it and other countries.
By every measure, inflation in the US has clearly accelerated since 2004. In 2005, the Federal Reserve’s preferred measure of inflation, the personal consumption expenditure (PCE) deflator exceeded 2% for the first time since 1995. The core PCE has continued to accelerate in 2006, and will likely top 2.5% by the end of the year. This is significant because the Fed’s stated aim is to keep core PCE between 1.5% and 2%. The steady acceleration of core PCE shows that inflation from rising energy prices has penetrated the broader US economy.
Despite the obvious acceleration of inflation, the Federal Reserve shifted monetary policy into neutral in late summer. The Fed has justified more accommodative monetary policy in the face of rising inflation by suggesting that slowing US economic growth will eventually mitigate inflation. This is a huge gamble because US inflation is being pushed higher by supply-driven energy price shocks rather than demand. In 2007, continued energy supply shocks are likely to feed a grain supply shock, stoking a sharp increase in food price inflation and further acceleration of core PCE.
The stated logic behind the Fed’s monetary policy change is spurious, to say the least. A 12-year-old child could grasp the idea that energy supply problems are pushing US inflation higher and that these supply problems are likely to intensify in 2007."(snip)
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