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.] 

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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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.