Commodity prices are running up again after stabilizing over the past several months. But even during the April-to-June plateau, the CRB commodity price index was well above price levels recorded in the first few months of this year. Price hikes are generally seen on commodity price indexes before they show up in the producer or consumer price index. It's one of the reasons that many investors - and Fed officials - keep a close eye on daily commodity prices as well as the price component of the monthly ISM manufacturing report.

Commodity price indexes reflect price changes in the raw materials that are key to production. When demand rises and production starts percolating, oftentimes commodities prices will also start escalating.

Accelerating commodity prices could be a signal to Federal Reserve officials, intent on avoiding inflation through pre-emptive monetary policy, to start tightening credit conditions. In fact, higher commodity prices do predict increased production, but don't always predict accelerating inflation as measured by the producer price index or the consumer price index.

Commodity prices predict production
The chart below compares year-over-year changes in the index of industrial production to the level of the ISM manufacturing price index. Remember that an ISM index level of 50 percent or more reflects a rising trend while a level below 50 percent reflects a declining trend. Notice how well the ISM price index correlates to the yearly change in production. It was only in 1997 and 1998 that the ISM price index was not rising sharply in tandem with production increases; this period is associated with the collapse in several Asian economies when strong deflationary trends for goods prices were imported to the United States. But even so, the direction of the index still moved in line with production.

The ISM price index appears to have bottomed out early this year at the same time as industrial production. The price index has posted levels above 50 percent from March through June.

Commodity price gains don't necessarily point to inflationary pressures
Food and energy prices fluctuate sharply and are often misleading indicators of underlying inflationary pressures. The chart below compares the producer price index at different stages of processing from crude materials to intermediate goods to finished goods excluding food and energy in each. The yearly change in crude materials prices are tied to the right axis (ranging from -20 to +25 percent) whereas the yearly change in the finished goods and intermediate goods index are tied to the left axis (ranging from -3 to +9 percent). Clearly, crude materials prices, even after accounting for the volatile food and energy components, fluctuate much more sharply than the later stages of processing. Sometimes, price hikes at the earlier stages are passed along to the finished goods index, but not always.

In the past six months, the crude materials index has risen somewhat dramatically, although from a very low base. The intermediate price index is only now starting to rise, but it remains below year ago levels. The finished goods index (also known as the core PPI) continued to moderate in the past six months and has yet to turn around.

Certainly, the recent price pressures in the crude materials index could eventually show up in the finished goods index. But judging from the experience of the 1990s, the amount that was passed through was small and came with a several month lag. Judging from this chart, the Fed hardly would be lax in their inflation fighting duties if they waited an extra month or two before they started to raise the federal funds rate target. (Indeed, the market consensus now shows that expectations of a rate hike are centered on November.)

We could look at the PPI for finished goods in a different way. The chart below separates out capital equipment (27 percent share) and nonfood, nonenergy consumer goods (38 percent share) from the finished goods index. Both key components are still moderating on a year-over-year basis. It is possible that these will turn around soon, but a bottom is not yet evident from the chart below.

BOTTOM LINE
Commodity prices have posted gains recently. While price hikes are not generally viewed in a favorable light, the commodity price increases have corresponded to increased production demand. Equity investors have long awaited the recovery in production. In contrast, bond investors are usually more worried about inflationary pressures and prefer sluggish growth. But perhaps bond investors need not fear imminent sharp gains in consumer prices. Historical data shows that commodity prices tend to be more closely correlated with production demand than with producer and consumer prices.

The quiescent inflation picture is allowing Fed officials to keep their federal funds rate target unchanged in the near term. This is proving a blessing during a time of shaky markets and healing industries, pushing back the need for the Fed to raise rates and tighten credit conditions.

Evelina M. Tainer, Chief Economist, Econoday