Fed Vice Chairman Donald L. Kohn in a speech yesterday, addressed a theory to which I am partial: the theory that low real interest rates have been a factor behind the continued rise in prices of agricultural and mineral commodities, including oil, over the last year.
The relevant excerpt: “Some observers have questioned whether the news on fundamentals affecting supply and demand in commodities markets has been sufficient to justify the sharp price increases in recent months. Some of these commentators have cited the actions of the Federal Reserve in reducing interest rates as an important consideration boosting commodity prices. To be sure, commodity prices did rise as interest rates fell. However, for many commodities, inventories have fallen to all-time lows, a development that casts doubt on the premise that speculative demand boosted by low interest rates has pushed prices above levels that would be consistent with the fundamentals of supply and demand. As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies, hence raising the amount demanded by people using those currencies. But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one.” (Speech at the National Conference on Public Employee Retirement Systems, New Orleans, Louisiana, May 20, 2008).
As real interest rates have come down over the last year, real commodity prices have accelerated upward despite declining economic growth. (See graph, where the commodity price has been inverted so that one can see the correlation visually.)
The effect of interest rates can be demonstrated both theoretically and empirically. I have argued that the effect can come through any of three channels: inventories, production, and financial speculation.
Historically, real interest rates have had an inverse effect on oil inventories (when controlling econometrically for three other relevant factors). Nevertheless, I have to admit that inventory levels have not over the last year risen in a way that would support the theory. I thus have to rely more on the other channels of transmission to explain recent developments.
Stocks of oil held in deposits underground dwarf those held in inventories above-ground, and the decision how much to produce is subject to the same calculations trading off interest rates against expected future appreciation as apply to inventories. (The classic reference is Hotelling’s Rule.)
Apparently the Saudis have indeed deliberately decided to leave theirs in the ground. “King Abdullah, the country’s ruler, put it more bluntly: “I keep no secret from you that, when there were some new finds, I told them, ‘No, leave it in the ground, with grace from God, our children need it’.’’ FT 5/19/08. I see the interest rate as part of the Saudis’ decision how much oil to pump. Because the current rate of return on financial assets is abnormally low, they can do better by saving the oil for the future than by selling it today and investing the proceeds. Holding back production raises today’s oil price, to a point where the expected future return on oil has fallen to the same level as the interest rate. Hence the inverse effect of real interest rates on real oil prices. The same logic governs others’ decisions regarding how much copper to mine, how much forest to log, etc.
In addition to the link from world real interest rates to world real commodity prices, there is the less novel link from individual countries’ real interest rates to commodity prices expressed in their own currencies, a link that primarily passes through their exchange rates. For almost all of the eight floating-rate countries that I tested, both the US real interest rate and the local real interest rate (as a differential relative to the US rate) simultaneously had significant effects on real commodity prices. The effect is equally applicable to the United States: When the Fed eases and the dollar depreciates, the price of oil in dollars goes up quickly. This despite what many have thought in the past, that there is little effect because oil is invoiced in dollars.
[...] [Technorati] Tag results for commodities wrote an interesting post today onHere’s a quick excerpt Fed Vice Chairman Donald L. Kohn in a speech yesterday, addressed a theory to which I am partial: the theory that low real interest rates have been a factor behind the continued rise in prices of agricultural and mineral commodities, including oil, over the last year. (Speech at the National Conference on Public Employee Retirement Systems, New Orleans, Louisiana, May 20, 2008). Excerpt: “Some observers have questioned whether the news on fundamentals affecting supply and demand in [...]
[...] 5. Frankel counters Kohn [...]
[...] for other reasons (whether low interest rates led to a rise in commodity prices- advocated by Jeff Frankel and countered by Kohn in this [...]
[...] Fed and Commodity Prices: On his blog, Jeff Frankel responds to Fed Vice Chairman Donald Kohn’s contention that Fed policy has had little influence on higher oil prices. “I have to admit that inventory levels have not over the last year risen in a way that would support the theory. I thus have to rely more on the other channels of transmission to explain recent developments. Stocks of oil held in deposits underground dwarf those held in inventories above ground, and the decision how much to produce is subject to the same calculations trading off interest rates against expected future appreciation as apply to inventories. (The seminal reference is Hotelling’s Rule.) Apparently the Saudis have deliberately decided to leave theirs in the ground, rather than pump now and spend or invest the proceeds. “King Abdullah, the country’s ruler, put it more bluntly: “I keep no secret from you that, when there were some new finds, I told them, ‘No, leave it in the ground, with grace from God, our children need it.” FT 5/19/08. I see the interest rate as part of the Saudis’ decision how much oil to pump. Because the current rate of return on financial assets is abnormally low, they can do better by saving the oil for the future, which raises today’s oil price to a point where the expected future return on oil has fallen to the same level as the interest rate. The same logic governs others’ decisions regarding how much copper to mine, how much forest to log, etc.” [...]
The High Commodity Prices and INFLATION - FOOD/OIL CRISES:
is directly link to commodity exchanges having LOWER MARGIN
REQUIREMENT on LONG PURCHASE POSITION around the world.
If MARGINS are increased to 100% of Value of Commodities..
Oil, Wheat, Corn, Gold, Metals, Rice……..
the PRICE will certainly come down to the levels where they were before 3-5 years.
MARGIN MONEY OF 8-10% can BUY full Value of commidity
on this Exchanges with LONG POSITION of 3-12month !!
While in REAL LIFE we need to pay Full 100% value.
I agree that the Fed’s moves with the money supply have contributed to wild deviations between price and value in various markets over the past ten years.
I believe that an under-appreciated point, however, is that liquidity should be treated as a variable independent from money supply in analyzing how and when bubbles form.
Some early work on this has been posted on my blog:
http://brokensymmetry.typepad.com/broken_symmetry/2008/05/applying-contro.html
Cheers!
[...] Frankel has acknowledged that, but also notes that perhaps oil producers are leaving those inventories in the ground. That could be one reason why the Saudi king rebuffed President Bush’s request for increased [...]
[...] Frankel has acknowledged that, but also notes that perhaps oil producers are leaving those inventories in the ground. That could be one reason why the Saudi king rebuffed President Bush’s request for increased [...]
[...] I’m not so sure. Speculation requires storage - something that was obvious in the housing bubble, but isn’t so obvious for oil.From Real Time Economics: Harvard’s Jeffrey Frankel, has argued for the idea that speculation is behind the run-up in price. He says that such behavior is due to the sharp reduction in interest rates by the U.S. Federal Reserve. Low rates encourage commodity stockpiling, he says, by making it less attractive to sell commodities and put the proceeds into bonds and other debt instruments.Critics of Mr. Frankel’s theory, including Paul Krugman, say the expected rise in commodity inventories hasn’t shown up. Mr. Frankel has acknowledged that, but also notes that perhaps oil producers are leaving those inventories in the ground. [...]
[...] Reserve. While I don’t think blame is necessarily the right concept here, I have been arguing that low real interest rates have worked to raise real commodity prices through a number of [...]
[...] I don’t think blame is necessarily the right concept here, I have been arguing that low real interest rates have worked to raise real commodity prices through a number of [...]
[...] COMPLEMENTARES: “An Explanation for Soaring Commodity Prices” e “Fed Modesty Regarding Its Role in High Commodity Prices” de Jeffrey Frankell; “Exploding commodity prices, lax monetary policy, and sovereign wealth [...]
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