This was to be expected.  It is an unseemly tooting of ones’ own horn, but –

“The traditional pattern is most clear with the carry from the yen to the euro:  it has been predictably profitable for the last five years, and this will predictably end soon, as the yen reverses its depreciation against the euro.”

Although the phrase “carry trade” became widely popular in the context of currency speculation, where scholars know it as the “forward discount bias,” its etymological root is in commodity speculation.     Broadly speaking, the same phenomenon is observable in housing, equities, commercial bonds, and emerging markets:   when money is easy and nobody is worried about risk (2002-2005), the search for yield sends the excess liquidity surging out of the low-interest currencies, and into all other assets.    When the process reverses, investors pull out of the risky assets and retreat back to the safe haven of the low-interest-rate currencies.   Over the last six months, the reversal of this broadly-defined carry trade hit equities and bonds first, and then commodities (having hit housing earlier, of course).   This month it is finally hitting the high-interest-rate currencies.

In the 1955 movie version of East of Eden, the legendary James Dean plays Cal.  Like Cain in Genesis, he competes with his brother for the love of his father, a moralizing patriarch.   Cal “goes long” in the market for beans, in anticipation of an increase in demand if the United States enters World War I.  Sure enough, the price of beans goes sky high, Cal makes a bundle, and offers it to his father to make up money lost in another venture.  But the father is morally offended by Cal’s speculation, not wanting to profit from others’ misfortunes, and angrily tells him that he will have to “give the money back.” Cal has been the agent of Adam Smith’s famous invisible hand:   By betting on his hunch about the future, he has contributed to upward pressure on the price of beans in the present, thereby increasing the supply so that more is available precisely when needed (by the British Army).  The movie even treats us to a scene where Cal watches the beans grow in a farmer’s field, something real-life speculators seldom get to do.
 
Among politicians, pundits, and the public, many currently are trying to blame speculators for the recent boom in oil and other mineral and agricultural products.    Are the soaring prices their fault?

Sure, speculators are important in the commodities markets, more so than they used to be.  The spot prices of oil and other mineral and agricultural products — especially on a day-to-day basis — are determined in markets where participants typically base their supply and demand in part on their expectations of future increases or decreases in the price.    That is speculation.  But it need not imply bubbles or destabilizing behavior.

The evidence does not support the claim that speculation has been the source of, or has exacerbated, the price increases.   Indeed, expectations of future prices on the part of typical speculators, if anything, lagged behind contemporaneous spot prices in this episode.   Speculators have often been “net short” (sellers) on commodities rather than “long” (buyers).  In other words they may have delayed or moderated the price increases, rather than initiating or adding to them.  One revealing piece of evidence is that commodities that feature no futures markets have experienced as much volatility as those that have them.   Clearly speculators are the conspicuous scapegoat every time commodity prices go high.  But, historically, efforts to ban speculative futures markets have failed to reduce volatility.

One can distinguish three kinds of speculation in the face of rising prices.   First, there is the “bearer of bad tidings” like Cal in East of Eden.  The news that, in the future, increased demand will drive prices up is delivered by the speculator.  Not only would it be a miscarriage of justice to shoot the messenger, but the speculator is actually performing a social service, by delivering the right price signal that is needed to get real resources better in line with the future balance between supply and demand.  Without him, the subsequent price rise would be even greater, because supply would be less.    Most economists agree that speculators did not play this role in the commodity boom that started earlier this decade:  as already mentioned speculation, if anything, lagged behind the spot price.   (An exception, however, is Alan Greenspan, who told Krishna Guha of the Financial Times that speculators played precisely this role, moving forward and smoothing out what would have otherwise been an even sharper peak in prices.)

Second, when the price is topping out, stabilizing speculators can sell short in anticipation of a future decline to a lower equilibrium price.   This type of speculator again adds to the efficiency of the market, and dampens natural volatility, rather than adding to it.

Third, in some cases, when an upward trend has been going on for a few years, speculators sometimes jump on the bandwagon. Market participants begin simply to extrapolate past trends.  Self-confirming expectations create a speculative bubble, which carries the price well above its equilibrium.  The markets don’t always get it right.   Examples of previous speculative bubble peaks include the dollar in 1985, the Japanese stock and real estate markets in 1990, the yen in 1995, the NASDAQ in 2000, and the housing market in 2005.

It is the third kind of speculation, the destabilizing kind (also called bandwagon behavior), about which people tend to worry.    As noted, there is little evidence that destabilizing speculation has played a role in the 2001-2008 run-up of commodity prices.    So far, that is.   Just because the boom originated in fundamentals does not rule out that we could still go into a speculative bubble phase.    The aforementioned bubbles each followed on trends that had originated in fundamentals (respectively:  rising US real interest rates, 1980-84;  easy money and rapid growth in Japan, 1987-89;  US recession, 1990-91, and Japanese trade surpluses; the ICT boom in the late 1990s; and easy US monetary policy after 2001).  

It is not hard to identify in economic fundamentals the origins of this decade’s boom in commodity markets:  easy money in the US; rapid growth worldwide, but especially in China and India; instability among oil producers, especially in the Middle East; misguided ethanol subsidies; drought in Australia, etc., etc.  

[Any readers wishing to comment on this blog post: I suggest you go to the RGE version.] 

 
President Bush yesterday eliminated a 27-year executive moratorium on off-shore oil drilling (NYT, 7/15/2008, p.A13), a move also supported by presidential candidate John McCain. 

The Democrats responded:

(1) that this was an election-year stunt,

(2) that the move would be too small to make a difference

(3) that it would bring no downward pressure on oil prices at the crucial short-term horizon, and

(4) that it would not ultimately help move the country in the direction of energy security. 

The Democrats have the right answer, but are perhaps giving the wrong reasons.

 No doubt they are right that it is a political stunt.  A Congressional ban on offshore drilling has been in effect since 1981, so the President’s action is moot.  But making a political point in this way is in itself fair game.  The Republicans are trying to blame high oil prices on the Democrats.   Similarly, the Democrats’ response could well be the right one from the viewpoint of political gamesmanship.

But I should try to stick to economics in my blog, rather than politics.  The issues can be slippery; but let’s take the bit in our teeth and drill down on what would make for good for policy.

On grounds of good economic policy the Democrats’ chosen arguments seem to me beside the point.  It is true that the oil in the offshore sites would not be enough to have much effect on the world price.  It does not amount to much as a percentage of world reserves, which is the relevant metric for determining the effect on price.   “The Department of Energy estimates that there are eighteen billion barrels of technically recoverable oil in offshore areas of the continentail United States that are now closed to drilling…[A]t current rates of consumption, eighteen billion barrels would satisfy less than seven months of global demand.” (The New Yorker, Aug. 18, 2008, p. 28.)  But if one believed there were no cost to more domestic oil drilling, then one should conclude that every little bit helps.  Basic economic theory tells us to judge proposals by the ratio of benefits to costs, not by the absolute magnitude of the benefits.

Regarding point (3), both parties are responding (unsurprisingly) to the American public’s great sensitivity to short-term prices for gasoline (in the summer) and home heating oil (in the winter).  No doubt high prices are causing a lot of hardship.   (And even if it takes ten years to develop new oil reserves, the knowledge that the oil was coming should put a bit of downward pressure on prices today.)   But market prices are high today for a reason.   What is the market failure that would call for government intervention in the oil market?

The most obvious market failures are the externalities that characterize air pollution and emission of greenhouse gases.  The ban on off-shore drilling was originally enacted in response to damaging coastal oil spills;  in the years since then we have also learned that the atmospheric damage from oil consumption is far greater than we had realized.  The environmental externalities of course are reasons for higher prices, not lower.   I am struck every time I see an article on politicians’ commitment to action on global climate change sitting side-by-side in the newspaper with an article on their opposition to oil price increases.   

I realize that higher energy taxes are politically out of the question at this point.   But I could imagine legislation that would automatically raise energy taxes if and when oil prices fall, thereby putting a floor at recent levels and providing industry with the clear incentive to undertake the long-term investment in energy-saving equipment and technology that we badly need.  Rebate the proceeds by fixing the AMT, or removing the payroll tax on low-income Americans, one answer to the income distribution point.  In any case McCain’s proposal for a gas tax holiday is a spectacularly bad idea.

The other obvious market failure that might justify government intervention in the market is national security, and here we come to argument number (4), and the central point of my post.  While Americans need to recognize that achieving complete energy security is an impossible goal, it should indeed by a national objective to reduce our dependence on imported oil.  We could thereby reduce our need to fight messy wars in the Mideast and to coddle unpalatable autocrats worldwide.  But, in the first place, conservation — not new drilling – is the largest and most sustainable component of such a strategy.   In the second place, as high as world energy prices are now by historical standards, this is not the worst-case geopolitical crisis that we should be seeking to protect our economy against.  That worst-case scenario is a prolonged loss of world access to Gulf oil stemming from some combination of military conflict with Iran, anti-Western popular uprisings in the region, terrorism, and/or nuclear or radiological weapons. 

Thus the Democrats have it precisely backwards. The problem with Republican proposals to re-open domestic oil drilling is not that we desperately need the oil right now, whereas new oil discoveries would not come on line for 10 years or more. Rather it is that we might truly desperately need the oil in 20 or 30 years, and so don’t want to use it up over the next decade.

 
The possibility that some Gulf states, particularly the United Arab Emirates, might abandon their long-time pegs to the dollar has been getting increasing attention recently (for example, from Feldstein and, especially, Setser).   It makes sense.  The combination of high oil prices, rapid growth, a tightly fixed exchange rate, and the big depreciation of the dollar against other currencies (especially the euro, important for Gulf imports) was always going to be a recipe for strong money inflows and inflation in these countries.  The economic dynamism — most striking in Dubai –  is admirable and fascinating as a longer term phenomenon, but also now clearly shows signs of overheating.  Indeed inflation has risen alarmingly, as predicted. Among other ill effects, it is producing unrest among immigrant workers.   An appreciation of the dirham and riyal is the obvious solution.

Most often discussed as an alternative to the dollar peg is a peg to a basket of major currencies.   This would be an improvement.   Kuwait, for example, made this switch a year ago.

But a basket peg does not address the fact that when oil prices rise generally (not just against the dollar), as they have in recent years, monetary policy is constrained to be looser than it should be.    Similarly, when oil prices fall generally (not just against the dollar), as they did in the 1990s, monetary policy is constrained to be tighter than it should be.   A floating exchange rate regime is the traditional alternative, on the theory that the currency would then automatically appreciate when oil prices rise and depreciate when they fall, thus accommodating the terms of trade shocks.  But there are serious disadvantages to small open countries floating, such as the loss of a nominal anchor for monetary policy. 

Today’s reigning orthodoxy is to add an inflation target as the new nominal anchor.  But this doesn’t solve the problem, if the targeted price index is the CPI, which gives little weight to oil, the biggest sector in production and exports.

I believe that a better solution would be to include the price of oil in the basket of currencies to which the Gulf currencies would peg.   I have laid out the case elsewhere (including also for the case of Iraq).  I call the proposal PEP, for Peg the Export Price.   I was pleased to see that the FT mentioned this option approvingly yesterday (“Dollar-pegged Out,” July 7):

“The Gulf needs to peg to something. A first step (after revaluation) would be to peg to a basket of currencies that included the euro and the yen. A bolder step would be to include the price of oil in that basket, so that currencies would appreciate when oil is strong, and depreciate when it is weak.”

 If you wish to post comments please go to the RGE version.   

Everyone is looking for someone to blame for high prices of oil and other mineral and agricultural commodities. Speculators (among others) are high on the list, followed by the Federal 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 channels. Each of these channels could be called “speculation,” if speculation is defined as behavior based on expectations of future prices.

A number of commentators, including Don Kohn and Paul Krugman, have argued that low interest rates and speculation cannot be the sources of the problem, because oil inventories are low. It is true that low interest rates, other things equal, should in theory increase firms’ desire to hold inventories.

US crude oil inventories do not appear to be especially low in the graph above, showing June 1998-June 2008 (from Bloomberg). But it is true that they are not especially high either.

We are talking about relatively integrated world markets, however, so it is world inventories that should matter most. According to the International Energy Agency’s Oil Market Report, oil inventories held in developed countries have been above average during most of the last year, as the next graph shows. They rose sharply in January 2008, which happens to be the month when the very aggressive cuts in US interest rates took place. These numbers are far from conclusive, but still…

The theory is meant to explain the mystery why prices of virtually all mineral and agricultural prices are high, not just oil, and in some ways fits others better. Inventories of some commodities are indeed high now. The price of gold, the last graph shown, is a good example. Here the evidence supports the theory (1) that easy monetary policy has driven up the price, and (2) that one channel is low interest rates making it more attractive to stockpile the yellow metal. But, as with oil, the biggest inventory is the one underground.

[Thanks to Pravin Chandrasekaran.]

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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.

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, copper 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 (think gold), 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. (For a simpler illustration, 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.

It is hard to remember now, but mineral and agricultural commodities were considered passé less than ten years ago. Anyone who talked about sectors where the product was as clunky and mundane as copper, corn, and crude petroleum, was considered behind the times. In Alan Greenspan’s phrase, GDP had gotten “lighter;” the economy was becoming weightless, “dematerializing.” Agriculture and mining no longer constituted a large share of the New Economy, and did not matter much in an age dominated by ethereal digital communication, evanescent dotcoms, and externally outsourced services. The Economist magazine in a 1999 cover story forecast that oil might be headed for a price of $5 a barrel.

Since then, of course, 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 (see graph). 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 energy, minerals, farm products, 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.

How to explain commodity prices up while the economy turns down? I will offer my answer in my next posting, tomorrow.