The inflation hedge of choice

On Wednesday, the US Federal Reserve "shocked the world" by announcing plans to buy $300bn of government debt and double its purchases of Fannie and Freddie securities. According to the FT, once the Fed's plans are fully realized its balance sheet could swell to $4,ooobn, one third the size of the US economy. Hellicopter Ben, meet Bazooka Ben.

The Fed's actions are an attempt to literally shock life into the credit markets. It may also have the convenient effect of driving down the cost of government borrowing. However, the Fed runs the very real risk of stoking a very big inflationary problem down the road. Weimar Republic the US is not, but the money supply is growing at such a rapid rate that the Fed had better hope the US economy rebounds this year. Remember central bankers, there are unintended consequences to such dramatic monetary easing; like say, a housing bubble (Mr Greenspan, I'm looking in your direction).

What then are some of the likely consequences of the Fed's policy innovations? For one, the dollar was the big loser last week; in fact, it registered its worst week against the major currencies in 24 years. This fed into an accelerating rally in commodities, the moment's inflation hedge of choice. The benchmark S&P GSCI index was up 8% last week. Or take copper, up some 28% this year, a feat completely divorced from the underlying fundamentals. Though, the FT has an article this morning on the actions of a "secretive" Chinese state institution stockpiling copper supplies (which sounds like the perfect plot for Bond film). Oil is back over $50, supported by the OPEC cuts, but boosted in recent weeks by Fed policy. The speculative inflow into commodities, as an asset class, may be small compared to the bubble of recent years, but it is nonetheless paring the steep losses experienced in the second half of 2008.

The sustainability of this rally is highly suspect. With Chinese growth forecast at 6% for the year, and the G7 contracting by 3.2%, the global recession will depress demand for commodities well into the year (with the possible exception of food, but that's another discussion). However, loosey-goosey monetary policy (as A-Rod would call it) comes at a price, with inflation second only to a loss of confidence in US treasuries. Bernanke has demonstrated that he is willing to throw everything in the Fed's arsenal at the credit markets. Until he wins, expect commodities to outperform as an asset class.

(photo courtesy of Shiny Things' photostream)