The Fed has come in for a surprising amount of criticism since its decision in the fall of 2010 to launch a new round of monetary easing — Quantitative Easing 2.  Ben Bernanke and his colleagues are right not to give in to these attacks.

            Critiques seem to be of four sorts. (Some are mutually exclusive.)

            1)  “QE is weird.”    Quantitative Easing entails the central bank buying a somewhat wider range of securities than the traditional short-term Treasury bills that are the usual focus of the Fed’s open market operations.    This has been a bold strategy, which nobody would have predicted 3 or 4 years ago.   But it has been appropriate to the equally unexpected financial crisis and recession.    Some who find QE alarmingly non-standard may not realize that other central banks do this sort of thing, and that the US authorities themselves did it in the more distant past.    It is amusing to recall that when Ben Bernanke was first appointed Chairman, some reacted “He is a fine economist, but he doesn’t have the market experience of a Wall Street type.”  The irony is that nobody who had spent his or her career on Wall Street would have had the relevant experience to deal with the shocks of the last three years, since none of them were there in the 1930s.  But as an economic historian, Bernanke had just the broader perspective that was needed.   Thank heaven he did.

            2)   “Monetary easing under current circumstances has no effect.”  It is true that, with short-term interest rates already near zero for the last two years, further monetary expansion is likely to be of less help than in a normal recession.  (The classic “liquidity trap” has been re-born as the “zero lower bound.”)    But monetary policy can work through other channels besides short-term interest rates.  Seven such mechanisms are: long-term interest rates, expected inflation, the exchange rate, equity prices, real estate prices, commodity prices, and the credit channel.   QE is worth a try, given that the economy is still weak and given the constraints that keep fiscal policy sub-optimal.

            3)  “Monetary ease will lead to inflation.   What we need now, if anything, is monetary tightening.”   This is the view, for example, expressed recently by some conservative economists, including John Taylor.   It seems to me way off base.  With unemployment far above the natural rate, GDP well below potential, and inflation (slightly) below target, it is clear that the Fed’s November 3 decision to ease further  was appropriate.

            4)  “The Fed is firing a volley in a destructive international currency war.”   This is the criticism that has come from some of our trading partners:  in particular, China, Germany and Brazil.   I don’t generally do “My country, right or wrong.”   But my country is right on this one.    Monetary easing is not a beggar-thy-neighbor policy.  The colorful phrase “currency wars“ seems to have confused some people.  The current situation is precisely the point of floating exchange rates:    when some countries feel that their high unemployment calls for monetary expansion (US) at the same time that others feel that their overheating calls for monetary tightening (Brazil, India, Korea, China…), an appreciation of the latter currencies against the former is precisely the way that floating rates accommodate the differences.    This is why Milton Friedman favored floating rates, so that each country could pursue its own desired policies independently.   I realize that the pressure which US monetary easing puts on countries like China to allow appreciation is unwelcome. China is finding it increasingly difficult to cling to its exchange rate target by means of controls on capital inflows and sterilized foreign exchange intervention.   But capital flows are a far more legitimate way to let China feel the pressure than the alternative:  Congressional threats to impose WTO-inconsistent tariffs on Chinese imports if it won’t allow faster appreciation of the yuan.

            I was glad to see that today’s decision by the Federal Open Market Committee to stay the course was unanimous.   The Fed is right not to give in to misguided criticisms.   This is what we have central bank independence for.

Click here for a TV interview on today’s FOMC decision, and inflation & TIPs.

[Comments can be posted on the Belfer site.]

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.