The weather vane is still there, but central banks have largely lost their mastery over the link between commodity markets and monetary policy. With booming raw materials markets driving the fastest inflation in decades, that’s a big problem.As a result, forecasting inflation in 2022 has become more art than science. What would be the Saudi king’s response to U.S. pressure to boost oil production? What’s Vladimir Putin going to do with Europe’s gas supply? How will Beijing react to record high coal prices? Perhaps that’s beyond the expertise of any central banker. Instead, most of them rely on rather unsophisticated tools to incorporate commodity markets into their models. Worst is their mechanical use of the futures curve for inflation forecasting.The futures curve is not a forecast of where commodity prices are heading but rather a snapshot of what the market is willing to pay today for delivery in the future. That’s one of the reasons that the U.S. Federal Reserve, the European Central Bank and others got inflation wrong last year. They assumed, looking at the shape of the price curves, that the worst of the commodity-price increases were behind them. Inflation, therefore, was “transitory.” Wrong.Central banks themselves are aware of the shortcoming. In 2012, the Bank of England published a paper about its troubles incorporating oil prices into its inflation modeling: “Despite the theoretical link between the futures curve and expected spot prices, the futures curve has not been a very good guide to predicting future spot prices, failing to predict the upwards trend in prices between 2003 and 2008 as well as the collapse and recovery in oil prices since then.” And yet, in the very same study, the authors argued that the bank should continue using the futures curve for its forecasts. One reason? It’s easier.(2) Today, the Bank of England assumes that, for the first six months of 2022, energy prices will follow the futures curve, and after that stay constant. In a tight market, as we have today, the shape of the futures curve is particularly misleading as a forecast. Take oil: The curve today is a steep downward slope — something called backwardation. That shape means buyers are willing to pay a premium for scarce barrels for immediate delivery. But the downward slope doesn’t mean that oil prices are due to fall. It’s just an indication of present demand.For the Brent oil market, the price difference between the contract for delivery in April 2022 and the forward contract for December 2022 is $10 a barrel. A central bank may interpret that as a sign that Brent crude is due to drop from $95 to $85 a barrel from now to the end of the year, a harbinger of weaker inflation.
Ask any physical commodity trader, and they will tell you how wrong that is. If central banks require a mechanical way to incorporate commodity price futures into their thinking, the options market offers a better alternative: The price difference between bullish and bearish options contracts — known as the put-call skew in the jargon — gives a better sense of what the market thinks is the balance of price risk. The options market right now is signaling that, on balance, prices may be higher in the future, not lower.
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Which brings us back to the question of expertise.
The major central banks have legions of economists who honed their chops in an era of unconventional policy: negative interest rates and quantitative easing. The focus of inflation modeling this century has been centered on prices excluding food and energy, removing the economy’s volatile elements. That is precisely the opposite of what we need now. Mathematical modeling of the latest economic theory may have its uses, but simple commodity demand exceeding supply doesn’t need extra bandwidth — it needs experienced eyes and ears on the ground.
Central bankers need intelligence about commodity markets. Outside the U.S. Federal Reserve, which has a network in the oil and agricultural industries thanks to its regional banks in Kansas City and Dallas, few other central banks knows much about what’s really going on in energy, metals and agricultural markets. If they want to get inflation right in 2022, central bankers should abandon their complex mathematical models and ask oil companies, miners and farmers what’s going on. They are likely to be surprised.
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(1) The International Monetary Fund looked in 2011 at the issuein a research paper, and found similar problems. Notably, the IMF said that “futures prices did a poor job as forecasters during the recent [2007-08] commodity price” cycle,
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Javier Blas is a Bloomberg Opinion columnist covering energy and commodities. He previously was commodities editor at the Financial Times and is the coauthor of “The World for Sale: Money, Power, and the Traders Who Barter the Earth’s Resources.”
Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.
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