Commodity futures and Inflation

Karan Sharma*

Commodity futures represent a bet on commodity prices; they are directly linked to the components of inflation. Second, because futures prices include information about foreseeable trends in commodity prices, they rise and fall with unexpected deviations from components of inflation. This is exactly why futures do well when stocks and bonds perform poorly.
Commodity futures returns are negatively correlated with stock returns. Commodity futures have opposite exposures to unexpected inflation from stocks and bonds. It is tempting to put both together and ask: does the opposite exposure to unexpected inflation account for the negative correlation between commodity futures and stocks and bonds? Preliminary findings suggest that this only part of the story behind the negative correlations.
India's high inflation rate, hitting three-year highs at more than 7% and coming amid record food grain production, is prompting demands for a ban on the increasing trade in food commodity derivatives. The Wholesale Price Index for food grains touched a record 222.8 this month, up from 210.4 a year earlier as the overall commodities derivatives market has climbed to an average of more than US$3 billion in daily trading turnover. The government, which a year ago banned trading of rice and wheat futures, appointed a now 13-month-old, four-member expert committee to check if a future trading is causing food prices to soar. The expert committee, expected to issue its findings on Monday, April 28, was forecast to refrain from recommending an immediate or future ban on futures trading in certain commodities. Futures trading aims to offset market risks and get better prices to producer, marketer and consumer, but the current inflationary crisis has intensified debate as to whether the gap is widening between rosy free market theories and the reality of unscrupulous market manipulation. Statistics point to an increasing rush in investments into the global commodities market, with a Citibank report claiming that investments in commodity indexes increased by $40 billion to $185 billion between January and March this year, a bigger gain than in the entire 2007. Yet commodity futures market keepers deny any link between the increase in investor interest in commodity trading and rising prices. "That futures trading in commodities causes’ inflation is a spurious co-relation," Prabhakar Patil, director of the Mumbai-based regulator Forward Markets Commission, told Asia Times Online. "Historically in democracies, a future trading has often been blamed for inflation and commodities banned from being traded, a trend going back to the 19th century." The Indian government banned futures trading in urad and tur (two popular pulses widely used in Indian cuisine), rice and wheat in February 2007, but government policies increasingly appear caught by conflicting tussles between various economic and political forces, within and outside the government.
Internal conflict has infected the Planning Commission, India's leading economic think-tank. Its deputy chairman, Montek Singh Ahluwalia, has strongly dismissed calls for a ban on futures trading in commodities and instead recommends a better-regulated futures market. But Ahluwalia's Planning Commission colleague Abhijit Sen, who heads the committee studying the impact of futures trading on commodity prices, conceded that the futures market could be responsible for price increases, an admission that immediately prompted a meeting of the committee on April 23 to sort out the difference of views. No consensus was reached. Market analysts believe otherwise. In an article headlined "Who pushes up your food prices? Gamblers!" the India-based trade site Commodities Online says, "The enormous influx of capital has resulted in the futures markets no longer reflecting supply and demand. Ironically, investors have placed their wildest bets on staple foods. Information about supply bottlenecks and famines at the other end of the world is not noted on market quotations." Studies by the Switzerland-based Bank of International Settlements (BIS) have also concluded a clear co-relation between the volume of derivative trading in commodities to sharp rise in commodity prices. India's fast growing commodity exchanges has grown 50-fold in barely five years and could expand to $1.8 trillion by 2010, according to an industry body report. People's Democracy, the weekly mouthpiece of the Communist Party of India (Marxist) demanded in an April 20 editorial that futures trading in 25 agricultural commodities be banned. Not just the communists, but India's leading industry body the Associated Chambers of Commerce and Industry of India also on April 20 called for a temporary ban on futures trading until the price rise crisis is reversed. Farmer groups are not impressed either. "Despite the good [food crop] production, there is a deliberate manipulation of the market," wrote Krishan Bir Chaudhary, president of the New Delhi-based Bharatiya Krishak Samaj (Indian Farmers Forum). "The farmers do not gain in the process as they are paid relatively lower prices than what the corporate houses quote on the futures exchanges or in the spot market, or at what the retail chains sell to the consumers." Chaudhary has called for the government to reject "this neo-liberal and corporate-led agriculture model and replaced it by a farmer-centric one". India joined the global furor and confusion whether commodity speculators and hoarders are part of the problems driving up prices, amid fears of the worst global food crisis unfolding since World War II. Josette Sheeran, executive director of the United Nations World Food Program, said on April 22 that rising food prices would leave 100 million people hungry in every continent.
Soaring food prices of rice, wheat and other staple grains are hitting the world's most vulnerable sections, say aid agency officials. The Rome-based United Nations World Food Program, that serves over 80 million people in 78 countries, revealed that food aid for 20 million of the world's poorest children will be reduced. Rice prices in Asia soared by 68% in a year, provoking the world's leading rice exporters such as India and Vietnam to ban exports of popular rice varieties, a move deepening anxiety of decreasing supply and increasing prices. Suspicions of artificial inflation could increase. Food grain production in India is set to touch record levels of 227.32 million tonnes (mt) this season (July 2007 to June 2008), up 4.6% from the year-on-year period in 2006-07, according to the third Advance Estimates of production of major crops grown in India. India's stance in the commodities market could prominently feature in the next round of the contentious World Trade Organization talks in Doha, Qatar, tentatively slated later this summer. The governmental dilemma seems a no-win situation born out of largely ignoring the agricultural sector until the pre-election year.

*Associate,Bank of America Continuum Solutions