Here’s why commodity prices are rallying

Iron ore saw its biggest one-day jump in value ever yesterday, reports Bloomberg. The price soared by a stunning 19% at one point.

It's partly down to hopes that China might be up for more "stimulus".

But there's also an increasingly convincing case to be made that we've seen the worst of the commodities bear market.

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And that's going to create some interesting dilemmas for the world's central bankers

What the commodity rebound is really about

As Bloomberg quotes one analyst from a brokerage in China saying: "The iron ore and steel markets have gone berserk they've departed from fundamentals and are heavily driven by sentiment. Investors are expecting further monetary easing by the Chinese government to boost steel demand."

However, this isn't a case of just one metal. As David Fuller points out on FullerTreacyMoney, "iron ore is doing what we are also seeing in most industrial commodities".

Miners produced too much. China's economy slowed. As a result, "a severe bear market developed in industrial commodities, based primarily on oversupply".

However, as always happens, low prices are proving to be the cure for low prices. Miners are getting back on top of the supply situation as the higher-cost producers shut down or cut back. "This is a recipe for explosive recoveries in the prices of exceptionally depressed metals."

The oil price has also been rebounding strongly. Brent crude poked its nose above the $40 a barrel mark yesterday for the first time in a long time. It's partly down to hope that big oil producers will decide to cut back production, say the news reports. There's a meeting of Latin American producers in Ecuador on Friday, for example.

However, again, this is getting the causality wrong. There are always rumours floating around about deals between Opec members, just as there is always "tension in the Middle East" the other classic line that's pulled out for every market report to explain an otherwise baffling upward move in the oil price.

Market reporters make up reasons for these moves after the fact. The reality is that it's not about demand. It's about supply.

You hammer prices hard enough for long enough, and producers stop producing as much. Some go bust, others just cut back. Eventually things come back into balance.

It's called the "capital cycle". Edward Chancellor spoke about thisback in in December. At the time, the clearest beneficiary of a turning capital cycle was the gold mining sector. After years of pain, gold miners had finally got their act together and were in a position to cope with lower gold prices.

Since then, of course, both gold and gold miners have performed exceptionally well. (You can read more about gold miners and why we think they've got further to go and importantly, how you can profit from it when you sign up for a MoneyWeek subscription).

If you don't move before inflation arrives, it'll get out of control

But if commodity prices have now at least stopped their relentless fall, then this could leave the US Federal Reserve and its fellow central banks with an interesting dilemma.

Central banks are of course meant to "look through" commodity prices when setting interest rates. At least, that's what they do when prices are rising. But they've been happy to assume that falling commodity prices are a sign of roaring deflation, just waiting to consume the global economy.

Indeed, the impact of falling commodity prices is one of the factors that helped to stay the Fed's hand when it last looked at raising interest rates. But it's going to be a lot harder to use as an excuse once those commodity price falls start to drop out of the annual inflation rate calculations.

Of all the major developed economies, the US is the only one where inflation (as measured by government statistics at least) is anywhere close to target levels. So might the Fed start taking a punchier approach to interest rates?

It's a tough call. On the one hand, Fed vice-chairman Stanley Fischer reckons the US may be seeing the "first stirrings" of inflation, due to the strong jobs market, reports the FT this morning.

On the other hand, we're now so close to the presidential elections that the Fed will be wary of being seen as making a political move.

And another Fed member Lael Brainard provides the perfect cover for inaction. Brainard warned that the Fed still needs to watch out for "weak and decelerating foreign demand". She also argues that the Fed needs to be very sure that inflation is actually moving back to target before it acts.

This is an interesting way to look at things. Pre-crisis, monetary policy was always assumed to operate with a "lag" of about 18 months to two years. So you had to predict roughly where inflation would be in two years' time, given planned monetary policy. Now the idea seems to be that you should wait until inflation hits the target, and then act.

It's understandable, given that central bankers have proved as bad at forecasting as everyone else. But it does suggest that as has pretty much always been the case monetary policy will end up being as "pro-cyclical" as ever.

If we have near-full employment, on target inflation, and near-0% interest rates well, that's a recipe for a lot more inflation.

No wonder gold and commodity prices are rising.

We'll be looking a lot more about how your portfolio can cope with rising inflation in a future issue of MoneyWeek magazine. You can get your first four issues freeby clicking here.