What are the implications of the continuing surge in commodity prices?

The first implication is that there is no shortage of global liquidity available to chase a “hot” investment theme. This is consistent with the current large gap between G7 real broad money supply growth and industrial output expansion – see chart. As I have argued previously, this gap is helping to cushion the effect of credit tightening on economies and markets.

Secondly, the commodity surge supports my view that Fed easing has been counterproductive, serving to boost inflationary risks rather than stimulate the real economy. The Fed should have waited for inflation expectations and commodity prices to soften before cutting rates aggressively.

Thirdly, the squeeze on G7 real incomes implied by rising commodity costs will sustain current economic weakness. However, I still think a recession / hard landing can be avoided and momentum will improve later in 2008 as looser monetary conditions offset credit tightening. More on that soon.