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The bubble accelerated sharply from the second half of 2007 as the Federal Reserve went on an unprecedented money printing binge to save the US banking system from collapsing under the weight of the sub-prime credit bubble.

Last week oil hit 135 dollars a barrel. There have also been food riots in poor countries as rice prices rocketed. Though the Bank of England and the European Central Bank policy have been less loose, they have also poured billions into credit markets.

"Maintaining present monetary stance would cause further inflammation of commodities prices, could disrupt supplies, and could cause significant world recession and disorderly financial markets," a new IMF study Recent Inflationary Trends in World Commodities Markets by Noureddine Krichene said.

"In order to rein in inflation and bring back a measure of stability in commodities and financial markets, monetary policy has to be tightened considerably and be directed to strictly controlling credit and money supply."

Even the financial crisis in the subprime market could be "easily traced to lax monetary policy", the study said.

"Similar financial crisis can be easily predicted in future as a consequence of overly expansionary monetary policy.

"Credit to economy has expanded at a fast pace in many countries, including major industrial countries, at the expense of creditworthiness and credit quality, contributing to a rapid increase in aggregate demand for real assets, goods and services.

"Credit expansion contributed to high speculation in many assets and commodities markets."

Misleading Indices

The study also pointed out that increases in commodities were not showing up in consumer price indices unlike two or three decades ago, a phenomenon which the research paper said needed to be further investigated.

"Most striking, consumer price indices (CPIs) in many industrial countries, a leading indicator for the conduct of monetary policy, were not sensitive to high increases in commodities or housing prices," the study said,

"In spite of a fast rise in housing, energy, and food prices, CPIs continued to show small increases, by about 2–3 percent in industrial countries during 2003–07, indicating puzzling price stability and almost no inflation.

"Such was not the case during the seventies, when CPIs were highly sensitive to oil shocks and rapid increase in energy prices."

But other critics had long pointed out that consumer price indices had been systematically perverted and manipulated to understate inflation in the last two decades, with the United States probably being the worst such case.

One of the worst such manipulations, the more sober central bankers now admit, is the use of 'core inflation' to guide monetary policy.

"Insensitivity of CPIs to commodities prices and to low nominal interest rates may lead policymakers to downplay the risk of inflation while there is ongoing abnormally high asset and commodities price inflation," the study said.

The bubble

Krichene studied three periods starting from 1973 when the United States defaulted on its obligations under the Bretton Woods agreement, and was forced to abandon the gold standard due to heavy money printing.

After 1973, the world saw the emergence of pure fiat central banking on paper money backed by nothing but government securities and independently floating currencies.

Inflation continued to be high in the 1970s as reserve currency central banks struggled to conduct monetary policy without a gold standard.

The IMF study pointed out that from 1973 to 1980 crude prices had bubbled by an average of 46.5 percent, gold by 31 percent, rice 14 percent and wheat 11.2 percent.

Around 1980 reserve currency central banks led by Paul Volcker's Fed went into strict monetary targeting bringing inflation and commodity prices (and gold) down to earth. This drove the US and parts of the world into a recession.

But crude oil prices expanded only 2.0 percent a year between 1981 and 1999, while gold fell 2.4 percent, rice fell 1.5 percent and wheat fell 1.7 percent. All commodities on average only rose 2.5 percent a year.

The bubble started to pick up in the 2000 to 2003 period and accelerated after 2003, when interest rates in some reserve currencies were near zero.

"…with the effect of expansionary monetary policy building momentum and demand expanding, commodities prices became almost uniformly under pressure…with price increases accelerating to unprecedented double digit rates," the study said.

From 2003 to mid-2007 crude oil had risen by an average of 30.3 percent a year, metals 32.9 percent, rice 13.1 percent, wheat 14.1 percent and gold 17.7 percent. All commodities had on average shot up by 23.0 percent a year.

Cold Water

The IMF study says aggressive Volcker-style tightening may be needed to bring commodity prices back down to earth and save the poor from starvation around the world.

The study poured cold water on claims that developing countries (China and India) were responsible for commodity inflation except in so far as some governments like India which restricted commodity exports or that inflation was 'cost push'.

"Without accommodative money supply, prices and exchange rates cannot sustain persistent changes," the study pointed out.

"The distinction between demand pull-cost push inflation becomes irrelevant, and the only way out of inflation is to restrain money supply and credit."

In any case no developing country had reserve currencies, and therefore they had no capacity to fire bubbles. But analysts say many developing countries which maintain soft-pegs with reserve currencies have amplified their own domestic inflation.

The study said to bring inflationary trends under control, central banks will have to "strictly reduce" money supply on Friedman-style prescriptions, but central banks are likely to face stiff opposition.

"Monetary authorities will face political conflicts stemming from debtors’ pressure to keep inflating the economy in order to increase their wealth and lower their debt burden," the study warned.

However the sub-prime crises had triggered a credit collapse and the IMF itself has said the commodity bubble may burst.

The IMF study comes as the Federal Reserve minutes released last week revealed it may end rate cuts.

The minutes also noted that "it was no longer appropriate…to emphasize the downside risks to growth," in an acknowledgement of central bank impotence, or the emergence of liquidity trap conditions where growth simply cannot be pushed by further money printing.