"Falling Interest Rates Explain Rising Commodity Prices"

Jeff Frankel has a good set of posts on commodities, both appearing on his blog and on Brad Setser’s (as guest blogger entries). We are featuring them together here. The first section (which was a separate post) argues that “world growth no longer explains soaring commodity prices“; the second argues that interest rates are now the major culprit.

Frankel does the useful service of trying to parse out supply/demand fundamentals from monetary/interest rate factors in the rise of commodity prices. He believes loose money (specifically, low real interest rates) is the big culprit. This will no doubt offend some readers (and also runs againt the argument of Marc Faber, that inflation-adjusted, commodities were exceptionally cheap in 2001 by very long historical measures). But Frankel’s analysis seems reasonable (and his view is shared by James Hamilton).

There are certainly bases for critiquing Frankel’s thesis. Supply issues in Nigeria in particular have elevated oil prices. Bad harvests and a fungal disease have fed the parabolic rise of wheat prices.

But consider Frankel’s fundamental observation: all commodities have moved up, more or less in parallel. And except for grains, they aren’t ready substitutes for each other. You can’t convert a coal fired electrical plant to gas. You can’t run a regular car on diesel fuel. Substitution takes time and investment. Readers also argue that energy costs affect agricultural prices, but I haven’t seen the impact quantified. The most persuasive argument that I have seen for a group of commodities moving together is agricultural products, where harvests have been faltering as demand is accelerating. The sharp rise in the cost of fertilizer due to diminishing phosphorus supplies (and that is a long-term trend) and the shift in emerging economies towards greater meat consumption.

From Frankel:
….we have seen tremendous increases in the prices of most mineral and agricultural commodities, many of them hitting records in nominal and even real terms. Oil is now well above $100 a barrel, and gold has just crossed the $1000 an ounce line.

The question is why.

There could well be merit to many of the explanations that have been offered for the rise in the price of oil; one is the “peak oil hypothesis,” and another is geopolitical uncertainty in Russia, Nigeria, Venezuela and – above all – the Gulf. Corn prices have been impacted by American subsidies for biofuel. And other special microeconomic factors are relevant in other specific sectors. But it cannot be a coincidence that mineral and agricultural prices have risen virtually across the board. Some macroeconomic explanation is called for.

The popular explanation since 2004 has been rapid growth in the world economy. The strongest growth has of course been coming from China and other recently minted manufacturing powerhouses in Asia, but the expansion has been unusually broad-based – including up to last year the United States and even a reinvigorated Europe. So growth has pushed up demand for farm products, energy and other industrial inputs, right?

This reigning explanation now looks suspect. Since last summer the US economy has slowed down noticeably, and is probably entering a recession. Despite talk of decoupling, it is clear that other countries are also slowing down at least to some extent. In its most recent forecast, the IMF World Economic Outlook revised downward the growth rate for virtually every region, including China. The overall global growth rate for 2008 has been marked down by 1.1% (from 5.2 % in July 2007, just before the sub-prime mortgage crisis hit, to 4.1 % as of January 29, 2008). And prospects continue to deteriorate. Yet commodity prices have found their second wind over precisely this period! (Up some 25% or more since August 2007, by a number of indices. So much for the growth explanation.

If strong economic growth is not the explanation for the large increases since 2001 in prices of virtually all mineral and agricultural commodities, then what is? One wouldn’t want to try to reduce commodity markets to a single factor, nor to claim proof of any theory by a single data point. Nevertheless, the developments of the last six months provided added support for a theory I have long favored: real interest rates are an important determinant of real commodity prices.

High interest rates reduce the demand for storable commodities, or increase the supply, through a variety of channels:
– by increasing the incentive for extraction today rather than tomorrow (think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled)
– by decreasing firms’ desire to carry inventories (think of oil inventories held in tanks)
– by encouraging speculators to shift out of spot commodity contracts, and into treasury bills.

All three mechanisms work to reduce the market price of commodities, as happened when real interest rates where high in the early 1980s. A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories, and raising commodity prices, as happened in the 1970s, and again during 2001-2004. It’s the original “carry trade.”

The theoretical model can be summarized as follows. A monetary expansion temporarily lowers the real interest rate (whether via a fall in the nominal interest rate, a rise in expected inflation, or both – as now). Real commodity prices rise. How far? Until commodities are widely considered “overvalued” — so overvalued that there is an expectation of future depreciation (together with the other costs of carrying inventories: storage costs plus any risk premium) that is sufficient to offset the lower interest rate (and other advantages of holding inventories, namely the “convenience yield”). Only then do firms feel they have high enough inventories despite the low carrying cost. In the long run, the general price level adjusts to the change in the money supply. As a result, the real money supply, real interest rate, and real commodity price eventually return to where they were. The theory is the same as Rudiger Dornbusch’s famous theory of exchange rate overshooting, with the price of commodities substituted for the price of foreign exchange.

There was already some empirical evidence to support the theory: Monetary policy news and real interest rates, along with other factors, do appear to be significant determinants of real commodity prices historically (see graph below).

But the events since August 2007 provide a further data point. As economic growth has slowed sharply, both in the US and globally, the Fed has reduced interest rates, both nominal and real. Firms and investors have responded by shifting into commodities, not out. This is why commodity prices have resumed their upward march over the last six months, rather than reversing it.

Another cautionary note comes from “Lessons from past commodity bubbles” in the Financial Times:

The massive divergence that is occuring currently between rising commodity prices and fading global growth momentum has led to many investors to question if there have been similar episodes in the past.

“Yes,” says Andrew Garthwaite, chief global equity strategist at Credit Suisse, but only twice in the past 38 years, during the summers of 1974 and 1980.

“Both episodes were periods of US recession that happened to coincide with major supply shocks and/or sharp increases in investment and speculative demand for commodities,” says Mr Garthwaite.

Global commodity markets are very tight but there has been no sudden supply shock similar to 1973/74 or 1979/80, according to Credit Suisse. Instead, the investment bank says the primary driver of surging prices today seems to be financial buying by pensions funds, hedge funds and investment banks’ proprietary trading desks.

Mr Garthwaite acknowledges that there are crucial differences between the situation today and the two previous episodes but he says there is a relevant message from history.

“Sharply rising commodity prices may at first trigger or exacerbate a growth downturn, but eventually weak growth gets its revenge, as falling real demand triggers speculative liquidation.”

And Mr Garthwaite warns: “It is one thing to put money into commodity markets, quite another to try and take it out again.”