Commodities are a great hedge against inflation. Everyone knows this. Which is rather unfortunate – because it isn't true.
The chart, below, shows this. It plots the Goldman Sachs commodity index in sterling terms, which is what matters for UK-based investors, against the consumer prices index. It's clear that there have been long periods when commodity prices fell even as consumer prices rose.
The link between commodities and consumer prices doesn't improve if we look at annual changes in the two. Since 1988 the correlation between the two has actually been slightly negative, at minus 0.06. This means that unusually high UK inflation is as likely as not to be accompanied by poor returns on commodities, rather than good ones. For example, commodities did badly in the early 1990s when inflation was high, but did well in the low inflation mid-noughties.
So, why aren't commodities a good hedge against inflation? One reason is simply that they are so volatile. Since 1988, the standard deviation of their annual changes has been 22.3 percentage points. This means that if their average annual inflation rate remains what it has been since then (6.9 per cent) then there is a one-in-five chance of them falling 10 per cent or more and a one-in-nine chance of them losing more than 20 per cent. This alone makes them a poor hedge against UK inflation. Secondly, UK inflation depends on much more than commodities. It's quite possible that a weak domestic economy will reduce domestic inflation while commodities rise, or vice versa. That's less the case in emerging markets, where things like food and fuel form a much greater proportion of the 'basket' used to calculate inflation.
You might object here that "things are different now". After all, we seem to have entered the world about which David Ricardo and Thomas Malthus warned us 200 years ago – a world in which diminishing returns in the supply of commodities mean that global growth will cause their prices to continually rise. Assuming that is the case, it is of course bullish for commodities. But even that does not necessarily mean inflation will rise. For this to happen, the Bank of England must continually allow inflation to overshoot its target. If it doesn't do this, higher commodity prices will cause not higher inflation, but simply a squeeze on real incomes.
Commodities will be worth holding – but as a hedge against falling profits or wages, not against inflation. If it's protection against inflation you want, buy index-linked gilts. Commodities are a rather better hedge against equity risk. Since 1988 the correlation between annual changes in commodities and the All-Share index has been 0.2. This is low enough to make commodities a decent way of reducing portfolio risk, even allowing for the fact that they have been volatile. If Ricardo's warning finally comes right – and rising commodity prices do squeeze corporate profits – then this will become even more true. Arguably, it's happening right now.