What the Latest Inflation Number Means for Coffee (and all Commodity) Prices

The overall framework in commodities is that a weak USD rallies commodities and a strong US dollar devalues commodities. This is the basic influence that we in commodities need to understand, and we just recently had a bullish commodity event: the US inflation number.

US inflation came in lower than expected and this was interpreted as being bearish the USD which is bullish for coffee and all commodities. In the paragraphs below, I explain why this is bullish for #coffee and #commodities and also why this bullishness may be short-lived.

Commodities in major financial markets, especially #futures, are priced in US dollars.

Pricing in dollars is in essence a “cross” like any currency pair. In other words, when a dollar is stronger it buys more “stuff”. This makes commodities cheaper. If it used to cost you $2 to buy coffee with a weak dollar, with a stronger dollar, now it only costs you $1.90. This is why a stronger dollar compresses #commodity prices and a weak dollar rallies prices.

Many factors influence the value of the USD (see full breakdown here), including the value of other currencies, however the largest influence (the “gorilla”) is the #FederalReserve.

The Federal Reserve controls the money supply, and those of us who know commodities know that low supply = high prices, and high supply = low prices. Therefore whenever the Federal Reserve raises the money supply it lowers the value of the dollar. A weak dollar raises prices in USD terms which causes inflation. A weak dollar can also stimulate the economy which is why the Fed does it, but when inflation becomes too high the Fed will reduce the money supply to control it.

Over the last couple years, the money supply has risen to unprecedented levels to combat the recession from Coronavirus lockdowns. This monetary expansion combined with monetary stimulus packages and supply chain disruptions has spiked prices and now the Federal Reserve has been contracting the money supply to try and combat this.

The most recent data point is that inflation has come down from 9.1% increase yoy in June to 8.5% increase in July. Prior to this the Fed had been hastily contracting the money supply to try and contain inflation without great effect. In other words, the Fed has been increasing the rate at which they contract the Money Supply.

The #FX market had therefore been very bullish the USD as they anticipated the rate of contraction of the money supply to increase until inflation has been brought under control.

The latest inflation data point (the Consumer Price Index/CPI) suggests that contracting the money supply is working though, and therefore the rate of contraction will likely not increase. This is why the inflation number was interpreted as bearish for the USD. It means the current trajectory of the Federal Reserve policy is working.

However, while the rate is not likely to increase, the contracting of the money supply will likely continue apace for some time.

The policy of the Federal Reserve is still to contract the money supply. Inflation of 8.5% yoy is still a long way from the Fed’s goal of 2%. This means that we are looking at a minimum of many months, and possibly years of contracting the money supply to get us on target.

For simplicity’s sake, I’ve left interest rates off of the discussion above. However, contracting the money supply has the effect of raising interest rates which is one of the reasons this policy is bullish the USD (Investors like earning interest).

In summary, while the lower inflation number takes some of the shine off the bullish dollar trade, it is only bearish for the USD in the short term (therefore only bullish commodities in the short term). Going forward, the contractionary (Hawkish) Federal Reserve policy will likely be bullish for the USD and bearish for coffee and commodities in general.

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