Big Selloff in Commodities May Help Ease Inflation

The recent pullback in commodity prices—particularly oil—is expected to have a moderating influence on inflation in the coming months, providing some relief for consumers, the stock market and the Federal Reserve.

Though the sharp decline in commodities may be short-lived, it should be enough to allow the Fed to hold off raising interest rates for the rest of this year. The central bank met today to discuss the dual perils of slower economic growth and rising inflation, and left short-term rates unchanged. Futures action saw traders lower expectations of a 25 basis point cut at the Fed meeting in September, to as low as 28 percent from 34 percent eearlier.

Lower demand for oil as well as optimistic harvest expectations for a number of grains have pushed prices lower across the commodities board. Oil is at a three-month low while corn has reached a four-month low.

Both have been considered primary culprits in inflationary pressures, which have proved to be a dangerous aggravating factor in the slumping economy. Their retreat has some analysts anticipating a prolonged period of help for price-weary consumers.

"I'm still in the camp that this thing is probably leaning towards being over with, and that's just because of the demand situation," said Mark Schultz, chief analyst at Northstar Commodity in Minneapolis. "In order to get that (demand) back you're going to have to go lower (price-wise) in commodities in general."

At least for now, the Fed is coming away looking smart when it embarked on an aggressive nine-month rate-cutting strategy that sent its key lending rate down to 2 percent, a negative real interest rate when compared to inflation.

See Baur's comments in video at left

Though the central bank will likely hold the line on rates today, the decision wouldn't have been as easy had inflation—and gas prices in particular—continued to escalate.

"I'm not sure the Fed is really in as much of a box as people think," Bob Baur, of Principal Global Investors, said on CNBC. "We don't believe inflation is as much of a problem as it appears."

What Could Take Prices Higher

Some, though, think a reversal on fortune is only one market incident away.

"I think it's a positive, certainly," said Kevin Kerr, chief analyst at Resource Trade Alert. But, he cautions, "I wouldn't read too much into it. I don't think the Fed has been right about inflation. We had a parabolic rise in a lot of these commodities. ... Now we're getting a correction, and you've seen an overcorrection in some instances. I anticipate that this is probably short-lived."

Oil prices could spike back up once demand for winter heating oil kicks in. Also, some analysts note the recent popularity of the short-oil trade—a bet that energy prices will drop—that will change once those positions are covered.

"I just really question whether we're ever going to get back to $100 and whether it can sustain that price," Kerr said. "There's a lot of resistance below $120. We can maybe break down to $100, but it's not going to be able to hold that level for any length of time. The fundamentals are still in place that drove these markets higher in the first place. We still have very strong demand worldwide."

But Schultz believes a general slowdown in global demand will temper any spikes in commodity costs. Grains supplies are expected to be higher this year not only in the US but also the rest of the world, further dampening expectations of massive food inflation.

And a Lehman Brothers analyst said that the slowing US economy in particular also will act as a weight on commodities and inflation in general, meaning also that the Fed will be under little pressure to raise rates.

"With oil and commodity prices not growing nearly as rapidly as earlier this year, headline inflation rates are set to moderate by the end of the year," Lehman economist Michael Hanson wrote in an analysis. "(The Fed) is likely to continue with hawkish rhetoric, reiterating its vigilance against inflation but also noting their expectation that slack in the economy should help mitigate inflationary pressure over several quarters."

Stocks Get Relief

During its meteoric rise oil developed an inverse relationship with the stock market on a day-to-day short-term basis.

Now that the oil trade is looking to unwind over the longer term, stock players are finding ways to benefit.

"Money is leaving the commodities and finding some other areas," said Ryan Detrick, an analyst at Schaeffer's Investment Research.

Among the favorite plays at Schaeffer's during the commodities breakdown is a long position in financials, which particularly held a strong inverse position to oil.

Generally, in fact, sectors that did poorly during oil's surge higher have improved greatly as oil has headed in the other direction. Detrick cited home builders, fuel-dependent airlines and biotech as particularly strong plays.

He pointed to the rise of ETF Biotech HOLDRs as an example of how the industry has surged during oil's decline. The fund has climbed more than 15 percent since June 1 after being virtually flat for the previous three years.

"Commodities is a place you don't want to be in, period. Every commodity stock has been dropping," Detrick said. "Money's going out of the commodities, which had been about the only sector that had been doing well, and is definitely moving into the more beaten-down areas."