The news certainly sounds alarming. Copper prices at a four-year high. Ethylene prices nearly doubling since the spring. Steel prices up 25% over the past 18 months. Now that Europe and Japan are recovering and the developing nations are growing smartly, demand is sure to keep rising. Can a surge in finished-goods prices be far behind? Is the long-feared roar of inflation about to be heard?
Certainly, commodities speculators would like everyone to believe that price pressures are mounting fast and that 1970s-style inflation will return. And some manufacturers facing higher costs would like people to expect steeper prices--and be ready to pay them.
SMALL IMPACT. But despite all appearances, a new, commodities-driven inflationary spiral is not about to take hold. In the 1970s, supply shocks to two vitally important commodities, oil and grains, kicked prices higher. Today, it's demand, dispersed around the globe, that's pushing up certain materials prices. However, those rising prices don't provide grounds for panic, for three reasons.
First, materials account for only about 10% of total production costs in the U.S. economy, so even a sizable price increase in a few commodities should have a minimal impact on overall prices. "The good news is that the incremental cost in final products of copper or aluminum is exceedingly small," observes William E. Byers, director of futures research at Bear, Stearns & Co. Labor remains the largest component of manufacturers' costs--and well-behaved labor costs should provide a buffer against higher materials costs, economists say.
Even in so commodity-intensive a product as a house, lumber accounts for only 15% of total costs. In an automobile, the steel component of total costs amounts to about 5%. Moreover, not all commodity prices have surged--chemical prices generally have risen only 5.2% this year, and they're expected to moderate some in 1995. Most important, though, the prices of those commodities that are consumed most heavily--energy and foodstuffs--have been stable recently and are expected to remain so. Commodity indexes that are weighted by usage have been similarly steady, while the producer price index has also been well-behaved (chart).
Second, even if materials prices continue to mount thanks to cyclical pressures, relief will be coming in a couple of years as new global sources of supply are developed. And third, the Federal Reserve Board and other central banks have been vigilant in their anti-inflation stand. They won't permit a commodity-induced inflationary spiral to develop.
The Fed's latest 3/4% hike in short rates should ensure that growth in demand for commodities is steady and sustainable, rather than sharp and short-lived, says Steven H. Strongin, director of commodities research at Goldman, Sachs & Co. And that means, on average, commodity prices will rise about 5% to 15% a year over the next couple of years, rather than spike.
It shouldn't come as any surprise that materials prices have been rising. Demand is strong both here and overseas. The U.S. is in the middle of a healthy expansion that follows years of restructuring. Slimmed-down producers are now cranking up to fill heavy orders, and capacity is constrained. At North American mills, orders for sheet aluminum are up 30% this year. Steel demand is up 9.2% in the U.S. this year and 2.3% globally. Mills worldwide are operating at 92% of effective capacity, according to PaineWebber Inc.
Around the world, growth is becoming more synchronized. Allen Sinai, chief economist at Lehman Brothers Inc., reports that 43 of the 45 countries he tracks are in an upturn. In some spots, there is no clear end in sight. Countries such as Taiwan, Indonesia, Thailand, and, of course, China, will have an unremitting demand for a wide array of commodities for years to come as huge infrastructure and other projects get under way.
NEW EXPORTERS. But it's not just demand that will be growing. These developing countries are also becoming bigger and bigger suppliers, mining and producing more materials for their own consumption and for export. Indeed, says economist Robert S. Pindyck of the Massachusetts Institute of Technology, "much of the initial macroeconomic growth for many countries is fueled by commodity goods exports," which then allow these developing countries to pay for needed imports. China nearly doubled its imports of primary commodities, excluding fuels, from 1983 to 1992. But exports of commodities excluding fuels grew at an even faster rate, giving China a surplus in this trade. Similar trends have also produced such surpluses in Thailand, Indonesia, and India.
Around the globe, the supply of commodities and industrial materials is getting a boost. Indonesia just signed a multibillion dollar deal to develop natural gas with U.S. partners. China's capacity in ethylene and ethylene derivatives (mostly plastics) is likely to rise rapidly enough to meet yearly gains of 10% in demand there for the next decade. In steel, Brazil will remain an important producer, while Korea, Mexico, Poland, and perhaps even Russia could add to supply in coming years. China is expected to produce 20% of the world's steel by the turn of the century, up from 12.6% in 1993, to meet growing domestic demand.
The countries making the economic transition from socialism to capitalism will be searching for new markets in which to sell their commodities and earn hard currency. Russia and other former Soviet republics possess vast reserves of oil, gas, and metals such as copper and aluminum. After dumping aluminum on the markets from 1991 to 1993, the Russians were persuaded last February to cut back sales, and they say they are adhering to the agreement. But producers would be eager to export more aluminum, copper, and other hard-currency earners, says Arkady Mitrovanov, vice-president of Raznoimport, a group that handles imports and exports of nonferrous metals in Russia. Exports of oil and gas, the biggest earners for Russia, could also be ramped up considerably. Oil exports will bring in about $11 billion this year.
COPIOUS CAPACITY. New supplies can't come onstream rapidly, of course, and for intermediate and processed materials, it takes a few years to get new plants up and running. In the meantime, cyclical pressures may well push materials prices higher. But given the potential for copious worldwide capacity and continued stiff competition among global producers, there's no good reason for an inflationary psychology to develop and justify the embedding of cyclical price rises in final goods prices. Price resistance in the U.S. remains strong at both the wholesale and retail levels.
What's remarkable about commodities such as copper today is not their high price, nor even the strong demand that exists for them. What's remarkable, instead, is that inflation-adjusted prices for most major commodities today are at or below levels of 120 years ago--even though consumption has grown forty- or fiftyfold. Commodity prices are notoriously volatile, but the long-term trend--to everyone's economic benefit--is down.