Commodity Prices including cotton challenge the world economic “consensus” of low consumer price inflation, and should we “expect the unexpected”?

We are seeing one simple economic trend the rising price of basic foodstuffs (and other commodities) have a ripple effect around the world. As I review the news media I see articles on North Africa and Arabia and the riots and revolutions and military crackdowns which are taking place. I see discussion of UK monetary policy increasing as our inflation continues its rise. Many other nations have joined China in raising interest-rates in response for example Vietnam has raised hers by 2% this week. Now I see that the International Monetary Fund is discussing it and the G-20 group of nations will discuss it this weekend. Unfortunately this is the same G-20 which flies across the world and travels in motorcades to warn us of the dangers of climate change! Hypocrisy are us you might say. However it is a wide ripple effect from one event. I am reminded of the image of throwing a pebble into a pond. There was a children’s programme in the UK which had the strapline “expect the unexpected” whereas most mainstream thought only expects the expected.

The possible far-reaching consequences of the rising price of cotton

Overnight has seen developments in the underlying cause. The Commodity Research Bureau foodstuffs index has reversed its recent dip and risen 4.72 to 489.71. Also I notice the fats and oils index rose by 4.08 to 540.66. So the heat is on again you might say. In addition we are seeing a move in what is another relatively basic staple as cotton is surging in price and is now over US $2 dollars per pound and indeed is at US $2.11 per pound this morning. This represents a limit up price which has been the situation since Wednesday. For those unaware of what “limit up” means this is a consequence of some exchanges having price limits when trading stops which may be for an hour or that day. For example US Treasury Bond futures have had limits and Japanese Nikkei futures have a 3% price limit. If you are an option trader called Shaun trying to hedge your position that can be inconvenient, although on the upside at least I got a break!

The basic fact is that cotton prices have risen by a concerning 45% this year. To give some further consequence of this until this surge the recent high was 80 cents per pound. Now I want you to perform a slight mental leap. What have been the driving forces of low inflation in the westernised industrial world? Well one of them has been cheap clothing often cotton based from the Far East. It would appear that not only is that now over but we are seeing the reverse and can expect price rises rather than falls from this area. A Japanese economist I exchange ideas with contacted me recently to say that she had been on a business trip to Bangladesh and such prices were rising quickly there which she expected to hit the UK over the next 6/9 months. If you do not believe it then take a look at the labels in your clothes. In the UK one company Primark has made a successful business out of using cheap cotton and clothing to undercut rivals and this business model has to be under question going forwards. I am sure international readers have their own equivalents.

On the subject of international readers I notice that I am getting some few readers in the Far East interested in my articles on Quantitative Easing and its consequences. Hong Kong,China, Vietnam and others. As I get only a small snapshot of detail on the total I wonder how much concern there is out there over the consequences of this continuing policy.

US Inflation:The Consumer Price Index (CPI)

If we look at the official US CPI one might be tempted to say “nothing to see here move along”.  Whilst it climbed 0.4% in January the year on year rate remains historically low at 1.6%. However this is a seriously flawed index as I pointed out in my article on the subject back on the 2nd of July last year. One major issue is that housing represents some 41.46% of this index and that most of this is made up of rental costs. So in essence it is unlikely to rise much and whilst I believe that housing costs should be an influence on consumer inflation I believe that using an estimate of what home owners think they might get in rent if they rented their home out does not work well in practice. So it understates the US cost of living possibly substantially.

I am not much of a fan of the UK/European method of CPI but it at least if used for the US shows a higher levels of inflation. The latest figure for the US is out of date but in December it was at least 1.9% versus the official 1.5%. So not much but a little better.

If we link trends we see that US Consumer Prices for clothing rose by 1% in January in a trend we can expect to continue and perhaps accelerate if we allow for more recent commodity price rises.

The UK and problems with calculating inflation

I wrote this on Tuesday after looking at the UK consumer inflation statistics about a change which had taken place.

Perhaps nice for the figures for now but if cotton prices remain where they are this will misfire fairly soon! For those who have not be following their rise cotton prices have doubled since mid-2010.

The Bank of England mentioned this subject a day later in its inflation report. Here is its view on what has happened and the effect.

It is likely that the previous collection practices picked up the seasonal falls in prices during the winter and summer sales, but did not fully capture the recovery in prices after sales had finished

That suggests that true clothing prices were around 5.5% a year higher than measured in the CPI, equivalent to adding 0.3 percentage points to aggregate annual CPI inflation.

The changes to clothing price collection methods are likely to have a larger impact on RPI inflation than on CPI inflation……….The changes to price collection practices will increase the dispersion of clothing and footwear prices, and therefore the impact on RPI will be larger than the impact on CPI. In 2010, the contribution of the formula effect to the CPI/RPI wedge increased by 0.3 percentage points, entirely reflecting clothing and footwear prices.


Firstly I welcome this move. If you spot a mistake the correct course of action is to put it right as quickly as you can and then look to learn from it. However there are some consequences.

1. The under-recording of UK inflation may have contributed to the Bank of England’s apparent obsession with deflation and disinflation and the way it has dismissed inflationary trends. Although care is needed here as it may suit the Bank of England to exaggerate the effects of this…

2. Those who hold or have held UK index-linked government bonds which are linked to the Retail Price Index may well be enquiring as to whether they have been treated fairly. There is an issue here where the bonds will have been following an index which has been reported at what we know now is the wrong price. As I believe in transparency I will declare that I  do have an interest here as my pension fund is “overweight” in such assets.

3. Those who have held UK index-linked savings certificates may be wondering the same thing. They may also be wondering if this is the real reason why there have been no new issues of such products recently.

I will contact the necessary bodies to find out what they plan to do in response to this and update when or perhaps I should say if they reply!

Confederation of British Industry report on UK manufacturing reports cost pressures

Reflecting strong cost pressures from rises in oil and other commodity prices, inflationary pressures remain intense for UK manufacturers in the February survey. A balance of +32% of firms predict they will have to raise prices over the coming quarter, following a similar expectation in January (+31%).

Dissent on the Monetary Policy Committee: Selling England by the Pound

Andrew Sentance who has been arguing against the consensus at the Bank of England since late last summer gave a speech yesterday whose timing can only be assumed was not an accident. He wanted to follow the Inflation Report with his own different views. He makes essentially three points which I highlight below.

The value of the pound on the foreign exchanges therefore needs to be one of the key areas of focus for the MPC as we seek to steer ourselves out of the current phase of high inflation…..

By raising interest rates sooner rather than later to help offset global inflationary pressures, the MPC can help reassure the financial markets and the great British public that we remain true to our inflation target remit and are not intent on “Selling England by the Pound”!

So to recap, I have highlighted three reasons why the “output gap” view that spare capacity would bear down on inflation might not have operated recently: the limited margin of spare capacity in the economy; the rebound in domestic demand growth; and a change in the pricing climate due to the accommodation of price and cost increases to ward off fears of deflation.

These interrelate and he feels that the “internationalisation” of the UK economy is a major reason why output gap theory has not worked. For those who have not followed this topic the consensus view at the Bank of England has been that the output gap will reduce inflation and then that it will eventually reduce it. At any point in time it is expected to work in 6 months time! Unfortunately so far it has not happened.


I entirely welcome some new evidence on new thinking at the Bank of England and whilst I feel the timing is late there is the cliché better late than never! Although to correct myself to a degree, Mr.Sentance is only espousing views which were in the past considered part of Bank of England orthodoxy. It would be interesting to get the opportunity to ask Governor King when he changed his mind on such matters as the answer (if I got a one) could only be revealing.

How dangerous is it that the consensus view is always to expect the expected?

I went to a lecture at the London School of Economics on Monday evening and the speaker suggested that reality for economics was represented by using reasonable assumptions to get one set of answers or a curve on a graph. I asked if the fact that expressing reality as a single curve ignores the fact that due to human subjectivity in reaction to events that there might be several alternative responses rather than just one. Accordingly this might explain why what are called Black Swan events or what I was taught as the serially uncorrelated error term keep catching mainstream economics out.

I would welcome readers thoughts on this issue.


22 thoughts on “Commodity Prices including cotton challenge the world economic “consensus” of low consumer price inflation, and should we “expect the unexpected”?

  1. Shaun I am neither an economist nor a meteorologist merely a small person. However, I cannot believe the rise in commodity and especially food prices can be laid at the foot of poor global weather conditions. I remember reading some while ago that “a rising (economic) tide lifts all ships”; can I be reasonably safe in assuming that these price rises are such a phenomenon – that one man’s price increase is another man’s wage increase? If this is the case, surely this will become the “new normalcy” and there is little the G20 (or any august body) can do to reverse momentum?

  2. “1. The under-recording of UK inflation may have contributed to the Bank of England’s apparent obsession with deflation and disinflation and the way it has dismissed inflationary trends. Although care is needed here as it may suit the Bank of England to exaggerate the effects of this…”

    Who still believes that such “under-recording” is the result of any “accident” or “error” rather than part of a deliberate strategy of manipulation and distortion?

    Anyone can make an error now and again; we are after all only human. But for there to be continuous evidence of actions and records which continuously understate and distort – that then clearly demonstrates not error, but intent! This with official statistics is thus a form of legalised extortion by government.

    As I have pointed out previously, this is part of the necessary toolkit for part government financing via debasement in a democracy, where votes are needed to retain power!

  3. Timely, Shaun. I agree with your point. Coincidentally, Stephanie Flanders has written an interesting piece on economists and their role and what accountability standards they should meet. I reminded myself of a piece of academic work which preceded the financial crisis. It was by Cifuentes Ferrucci and Shin called Liquidity Risk and Contagion. I am not an economist but take an interest in this and what role the regulators played in the Great Crash of 2008.

    If you read this paper you will see a combination of academic simulation but tweaked with common sense as to how credit risk was being transformed in to market risk creating interconnected risk channels. This was written in April 2004. I am yet to find out why it was not taken on board quickly.

    • Hi Shire
      Thanks for the reference. I suspect we are in the moral hazard zone here or at least I am explicitly and Stephanie is implicitly…….

      As to your paper it was simply inconvenient for the consensus at the time and was therefore ignored. Just like the research paper at Merril Lynch on Anglo-Irish Bank and other examples. This fits in with the lecture I went to which was given by Edward Hugh. In a nutshell he came to my attention due to his work on the economic implications of aging and the Spanish housing boom and bust. The lecture was on mainstream economics and why it had gone wrong which was why I asked the question I did. I do not know if that lecture led to Stephanie writing what she did but can say that I did not see here there.

    • Hi Andy
      There are essentially 2 possible explanations.
      1. A mistake. I know it should not happen with just under 16 billion Euros but as I was discussing today we do get such Black Swan events from time to time.
      2. An institution is desparate for cash and it is likely to be a bank.

      For those who do not follow the story the European Central Bank has a weekly operation called a MRO at which you get cash if you want it and the charge is 1% per annum. It also has an emergency lending facility at which you can borrow overnight and the charge is 1.75% per annum. The latter is mostly avoided because it is more expensive and also because it is like a neon sign suggesting that someone is in trouble!

      For the past 2 days the emergency lending facility has risen by 15.8 billion Euros leading to a lot of speculation. As the next MRO is not until the 22nd we may have to wait until then. So ironically the more serious the problem the quicker it may disappear! If it is a mistake then the money will be taken again at the MRO on the 22nd as it presumably should have been this week.

      It is possible that an Irish bank is at the bottom of this as without writing an essay they have been exchanging bonds worth 17 billion Euros as a way of getting collateral usable at the ECB.Regular readers will be aware that the Irish Central Bank has been printing its own theoretical money and the problem may be linked with that. In some ways this is hopeful as we already know they are in trouble….

  4. surprised nobody has mentioned the reason the output gap hasnt worked is because the mechanism for higher commodity prices isnt from excessive Aggregate Demand but from investors piling into commodities on the basis of QE. Thus commodity prices rise from investors buying which drives inflation and the extra QE cash is absorbed before any increase in output. surely this is rational expectations, something that was identified in the 80’s and 90’s…. ?

  5. Hi Shaun,
    Has anybody done any analysis on the output gap? In NZ we have excessive capacity however after 10 years miss-allocation of resources our excessive capacity appears to be unemployed land agents, mortgage brokers and the such like. It is going to take some time to allocate such flop-sum and jet-sum to the productive economy. What is the spare capacity made up of in the UK?

    • Hi Bones
      I have taken a quick look at some of the literature and it would appear that your Reserve Bank thinks you have an output gap of around 10% like the UK. Oh dear, if any UK economists have influenced this let me apologise on their behalf!
      In terms of the theoretical concepts I have replied to Chris explaining my views on them and your question hits on point 4 I have there. The truthful answer is that we do not know but the more dynamic an economy is the better it is at coping with such eventualities. This leads to the irony that the less accurate the assumptions underlying an output gap are the more likely that it is the sort of economy that can shrug it off….for example the individuals you quote may only have those skills or they may have more transferable ones.

      It sounds as though some of the UK spare capacity is similar to NZ. Although in my view the only places where you could have a stab at measuring it would be say in manufacturing and construction which comprise say 20% of the economy which leads to the obvious question what about the other 80%?

      Speaking of people called Chris there is one Englishman with that name who has no “output gap” at all and whose productivity is positively Stakhanovite but “Le Crunch” awaits him and with the French we are back to my theme of expect the unexpected…..

  6. Government economist statisticians job requirement : selecting statistical data that matches the results desired by the politicians. Compare the official US CPI to the over 7% estimated by shadows stats.
    Alan Greenspan claimed that it was difficult to spot bubbles, but it is easy to see an increase in household debt and/or government debt and liabilities. Maybe the central bank’s mandate should include the prevention of excessive debt. The central bank could raise interest rates to discourage excess borrowing and encourage saving. But Mr King cannot cope with 1 variable (inflation over 4%) so why confuse him with borrowing to GDP ratio ?

    In regards to black swan events, some markets move according to conventional wisdom. For example 5 or 10 years ago many investors bought foreign real estate on the belief that property prices would continue to rise. When a herd of investors follows conventional wisdom, a bubble often results. Why look for nasty economic surprises when you can follow a convenient theory ?

    Contrarian investors like Warren Buffett prefer to make profitable investments in preference to changing conventional wisdom.
    Black swan events cause the losing investment bankers to make loud excuses about the unexpected event. The winners quietly pocket their bonuses.

  7. Can someone answer a naive question, namely, what percisely is this “output gap” and the “spare capacity” that everyone is talking about? I get the idea that the economy is not producing as much as it could: and that in theory this means that supply can exceed demand – keeping prices down.

    But surely, this implies a lot of production faciltiies that are geared up to produce – and competing for what demand there is. Do we really have lots of under-utilised plant? Or is the “spare capacity” merely the number of unemployed people who could be employed?

    Can there be “spare capacity” in a consumption-led, import-based economy: if consumer demand falls then is their “spare consumer demand”?

    In a service based economy, is the fact that a hairdresser is not working 100% of the time a measure of spare capacity – and, if so, do they get more business by reducing prices (buy one get one free?) or more revenue from increasing them?

    I have a depressing feeling that this is another of those simplistic theoretical models that everyone takes for granted and acts on as an article of faith – without checking whether it actually works.

    • Hi Chris
      To my mind there are various problems with this theory but let me first run through it. The OECD defines it thus.

      “An output gap refers to the difference between actual and potential gross domestic product (GDP) as a per cent of potential GDP. ”

      Translating this they mean the following. When an economy goes into a recession or depression then output falls. For example over the UK recent recession our economy had a fall in Gross Domestic Product which is our measure of economic output of around 6%. You could call that the “output gap”. What is usually added to this these days is the fact that if the economy had not gone into recession it is assumed it would have been growing and so past growth is looked at to give an idea of what is called trend growth to add to the output gap. There is debate over what trend growth is but for now lets just call it average economic growth in the pre-recession period. Doing this type of analysis led fans of such analysis to calculate an “output gap” of 10% of economic output or GDP for the UK. As an example I remember a speech by I think Mervyn King but certainly a member of the UK Monetary Policy Committee who used this figure.

      Now just to go to the logical consequence of this you would accordingly feel that demand pull inflation is unlikely and this has been the Bank of England position. This of course does not explain why they think other forms of inflation could not happen unless they think we only have demand pull inflation or more likely that it would outweigh the other forms.

      In essence my criticism of this theory is that it is a theoretical concept which at times has a tenuous grasp on reality for the following reasons.

      1. We measure economic output by GDP numbers. These are often revised sometimes fairly heavily. After a couple of years they should be reliable but we never actually know that they are or were right.
      2. Adding trend growth is a further theoretical addition which uses numbers we do not know are accurate to project a series which is even at the best of times argued about. These are not the best of times and previously reliable sequences are breaking down everywhere. So potentially there are quite large errors here.
      3. We do not know its relative impact compared to other types of inflation. Its adherents have given the impression at periods that they think it is the overriding type. The evidence so far it that it is not.
      4. It relies on something similar to the steady-state theory of the creation of the universe. In that there is a stable economic capacity and this is where your points are well-made. Some parts of the boom economy do not exist now. Some individuals will have to learn new skills and some factories will not be needed. This hits on a theme I have that the economy is more dynamic that this sort of model assumes. It is the reverse of what I call the bureaucratic type of view of the economy which the establishment has as to them things are usually staedy state where as in my view real progress is often quite innovative and may even escape official measures.

      These are the reasons why I think a policy error has been made in the UK as theory has been clung to like a liferaft when reality has told another story.

    • Sir, I believe the “Hamburg problem” may well prove to be a big problem for Mrs. Merkel but as the economy continues to improve (from a steep decline) it may well be that people in general return to their “feel good factor” and that the future election will be favourable to her. There is still time for her fortunes to turn.

      • Hi Ray and Mr.K
        I think some caution is required as for example my country has a long record of strong by-election results which are not repeated in a general election. However I believe Germany has other elections in March and they will now be watched for a trend, particularly by Mrs.Merkel…… I too have been waiting for a fuller picture as it will be interesting to see how much influence Alex Webers recent move has had on the wider populous in Germany.

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