The Bernanke held the line yesterday.

Everyone is talking about those comments in Atlanta where he suggested again that rising commodity prices, and the consequent inflation, are not a result of easy Fed policy.

Hmmmmm ...

Maybe not a result of ONLY Fed policy - but at this stage it is hard to argue against what low interest rates and quantitative easing have done to the demand for physical commodities and commodities as financial assets.

It is even hard for the San Francisco Fed to argue. But they tried. And their efforts have been met with much-deserved criticism. If ever you thought the Fed had a credibility issue, this is another piece of evidence to add to that mounting list. Look first at the conclusion of this paper:

Our analysis does not provide evidence that Federal Reserve large-scale asset purchases fueled the rise in commodity prices. It shows that, despite the fall in long-term interest rates and the depreciation of the dollar, commodity prices fell on average on days of LSAP announcements.

In case you’re not counting along at home and don’t want to read the entire paper, Large-Scale Asset Purchase (LSAP) announcement days numbered 11. So the average change for commodity prices on those 11 days was negative. Boom. End of story. QE, taken alone, puts downward pressure on commodity prices. Period.

Jeeze.

An explanation? Well, they say, maybe the fact that the need to implement one and then another round of quantitative easing signals that there are risks the economy is not in a good place. And we all know that risk-averse capital flows are not generally commodity-supportive. Gee, thanks.

Sure, the paper correctly acknowledges the impact that global growth and adverse weather conditions can have on the supply and demand of commodities. But the way the writers of this paper slither around the Federal Reserve’s actual influence on commodities is border-line insulting. Here is a chart of the S&P 500, Goldman Sachs Commodity Index futures, and the ThomsonReuters/Jefferies CRB Index – marked in vertical blue lines are major announcements of or about quantitative easing measures; marked in vertical grey lines are other announcements of LSAPs.

Click on image to enlarge!

And here is a chart of the ThomsonReuters/Jefferies CRB Index and the US dollar Index:

Click on image to enlarge!

The Fed has sought explicitly to boost growth in the US (and, implicitly, around the world.) They have achieved that. Thus, the demand side of the equation has very much been influenced by them, regardless of whether we’re talking about physical demand or financial demand. Again, commodity bulls have hit the turbo button because of these reasons:

1. Increased market speculation
2. Supply disruptions in the form of geopolitical tensions and adverse weather
3. A falling US dollar due largely to unattractive interest rate differentials
4. Growth in emerging economies

It seems the Fed has had a hand in at least 2 and a half of those reasons. And they’re likely not going to change policy a whole lot. What will change the risk appetite trade for commodities et al?

1. The US dollar catches a sustained bid because ECB rate activity has been overplayed and ongoing troubles among the Eurozone periphery have been underplayed.
2. US growth expectations fade in the face of expiring QE2.
3. Prices rise so sharply that it starts eating away at incomes and, thus, demand.
4. Tag-team of China tightening and Japan crisis-induced slowdown.

Granted, inflation is still low in the United States ... even though it is running faster elsewhere. And the geopolitically-driven price of energy is a large component of rising consumer food prices (added to the rising cost of agricultural commodity prices.)

Click on image to enlarge!

And since commodities perform well during periods of rising inflation expectations (see below from JP Morgan), I wouldn’t alter your portfolios just yet – but be aware.

Click on image to enlarge!

For more from Jack, visit Black Swan Capital and register for their daily newsletter, Currency Currents.