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.

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.