Falling Interest Rates Explain Rising Commodity Prices
Jeffrey Frankel
Note: this post is from Jeffrey Frankel filling in for Brad Setser
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, gold 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, 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 (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.
This post also appears on Jeff Frankel’s Blog.
Dr. Frankel - thanks for this post. With U.S. interest rates likely heading for negative territory in real terms, how much higher do you think commodity prices might rise?
that is, could commodity prices be nearing a point where they are overvalued despite falling interest rates?
If I might take the argument to the extreme: Assuming that indeed lower rates drive commodity prices even in times of weak growth expectations, what will happen once rates will start rising again as economic growth picks up again?
When returns on money are negative it is rational for people not to swap their goods for it. This process naturally leads to hoarding of commodities as a way of protecting wealth/savings from devaluating money.
There is very little danger for real rates to go positive in the current environment because of the problems in the housing market and the financial sector.
For individuals looking to protect themselves the problem is the marginal utility of most commodities fall off fast after their hoarding builds up past a critical point. The commodity with the least falloff in marginal utility should be favored in the current environment.
Ok, so this all makes good sense.
But it also very much begs the question “what duration?”
In the current environment, the Fed is cutting short rates every which way from Sunday. However, a rethink of dollar support by our Chinese and other international financiers threatens to push longer rates up.
Where is the “real” interest rate in this environment? Short rates are cheap but LIBOR spreads are horrific. The 10 year rate is low but threatens soon not to be. In some areas (to invetment banks that take too much risk) money is flowing like manna from heaven, in others (hard-working guy with a good credit rating), you can’t get a loan to save your life.
How do commodities respond to what’s going on in this tug-of-war?
Interesting. But where are the stats showing ridiculously high stocks of commodities.
According to this theory, oil is being pumped flat out. If this is true, then OPEC and others have opened the spigot as as much as possible.
The U.S. uses approx 68 barrels of oil/1000 people/per day. China uses approx. 5 and rapidly increasing.
And if, as I noted in my comment on the prior post, the world is adding 78 million people per year, we are in a world of hurt.
Now consider that all the other commodities that are being produced flat out.
From this point of view, does India or China stand a chance, both of whom presumably wish to lift millions out of poverty?
Nonetheless, even though the implications of your statement satisfy my “neo-Malthusian” leanings, it seems a bit too simplistic.
Brad could you replace the real interest rate by the monetary growth of M0 M1 M2 M3 and see how it looks. You could try also M0-Y (money growth in excess of production growth).
My bet is that commodity prices as soon as the monetary base start to really fall …
Interest rates tend to be falling when economic growth is slowing. Stocks tend to be falling when economic growth is slowing. Commodities tend to rise when stocks are falling. That interests rates tend to be falling when commodities are rising, yes may fuel the fire to some small degree but certainly cannot be held culpable as the main thruster.
The longest bull market in commodities in the 1900s began in 1933 when clearly economic growth the world over was stagnant. The reason for the increase in commodity prices was the cyclical under investment in commodity supplies over the previous two decades. Remember also that the supply side response is certainly not instantaneous. In fact in our present secular commodities bull which began in 2001, virtually no producers believed this was a long term bull market until very recently. Only now is investment being applied to bring on significant new supply. The catch? For most commodities it takes years and years to bring on new supply. Oil and base metals - minimum 8 years. Ags less, but significant.
The real story is supply and demand. Interest rates are a happenstance. Usually monetary inflation has worked its way through bonds, stocks and real estate, then ultimately shows up in prices. So while interest rate reductions surely fuel the fire, the easy money policy of the previous two decades actually contributes more so.
Chindia demand is not driven entirely by artifically low interest rates. In fact, one could argue not at all. What’s interesting today is that cyclical undersupply in commodities is being met with monumental demand. New middle class demand which can only be comparable to that of the period 1946-1960 when the U.S.,Canada and Japan developed their own middle class. Approx. 55 million people moved into middle class during that period. Today 40 million people PER year are making that transition.
So while commodity price increase seem sharp so far, the likelihood is that despite possible future sharp setbacks along the way, prices are poised to move much, much higher. The supply side response has simply not been adequate while demand escalates. Interest rates up or down, the infrastructure buildout is being driven by governments with large surpluses.
I don’t agree with this analysis.
As incomes rise, the composition of purchases changes. When incomes rise from $200 to $400 per year, most of the rise can be expected to go into food. But when incomes rise from $10,000 to $20,000, the increase probably goes more into things like cars, larger living quarters, and so on. China and India are in between those two levels. We are, in my estimation, seeing the non-linear rise as the Gaussian curve of income shifts. If incomes continue to rise, commodity demand can continue to rise ahead of growth, which is an average.
@JA
I do not think ag needs to lag as there are incredible market incentives right now to increase supply. Land in the US and EU can come out of subsidized set-aside programs if the price is right (and I think we are in this now). There are alternatives for oil; it’s the long term price that will be key to supply. Demand, while inelastic does come down for awhile. The key is do we have a breakthrough that can shift demand in addition to reducing it (electric cars via improved batteries) and when.
@Dr. Frankel
I agree with your copper assessment. Real interest rates do foster a move into commodities. In the prior periods you cite, there were no such things as ETFs for commodities, so I think we are in unchartered territory and it will be possible, via asset allocation AND speculation to overshoot the logical target value of commodities based on demand. In short, we could well end up with a commodities bubble because of low relative interest rates.
I agree with JA that the commodity price rise is primarily a result of supply and demand.
We’re seeing an annual decline rate in oil production of roughly 6 million barrels per day. Russia, which has been responsible for much of the new production offsetting the decline rate, is now also in decline. Angola, another major source of new production, has just gone flat. Saudi Arabia is pumping about all it can sustainably pump.
The real engine of economic growth is energy growth. If you can’t get energy growth, your only chance of growth is an increase in energy efficiency. Oil supply stopped growing in roughly spring of 2004. In fact, because it is taking more rigs and more energy to get the same amount of production, oil supply has been in a slight decline since that time. We have been using debt for growth since then because we have not increased efficiency sufficiently to get any real growth that way.
Energy efficiency gains will have to outpace an increasing energy supply decline rate in order for us to ever see growth again.
In my view, lower interest rates (in response to lower growth) are caused by declining energy supply and higher energy prices, exactly the opposite of what you propose.
Moe
Falling interest rates and falling currency what a wonderful combo for the speculative bubbles that ensue.
Another debacle will be gold and that will trigger a liquidity crisis.
The piece above explains why commodities prices are up and rising in US$. This is a world wide phenomenon. We exported, not democracy but our insane banking and risk taking system to the rest of the world. The rest of the world hasn’t yet gone into a recession but they will due to bad loans and rising commodity prices. The US is just the first to have a down turn in economic activity. The world will follow. They have to because commodities are the basis of everyone’s standard of living and the commodities cycle as explained in the piece below is world wide. Rising commodities prices take away from income that once went to service debts. The lower interest credit cycle loans are already done. Now the lower interest is doing nothing, except to margin players. Loan activity is diminished across the board due to a phenomenon called debt revulsion. Yet excess dollars are already out there. Money is just not where it is needed to pay back existing debt. Cycles! Just the way of the world.
Most people relate inflation to rising prices not the creating of excessive credit due to low interest rates. In the current case, we also added in lowered qualifications for borrowing to make matters much worse.
In the past this was corrected by two factors. As commodities pricing effects the cost of everything made from them including food and energy, there was always a great clamor to stop inflation. The way to stop inflation is to raise interest rates to the point of making it a better investment to put your money in a bank to loan out than to invest in commodities to hoard. This cycle is not going that direction. The US can’t afford to do that either because of all the public debt. The government is in the same boat as the people except that they can create money out of thin air to pay off existing debt.
The other factor was that in the past, production of all commodities rose to meet the fictitious demand from hoarding and when the two events of a slow down in demand and rising supplies crossed, that eventually brought the prices of commodities down. This doesn’t look all that positive either.
Today we have a few additional factors to deal with. The US is no longer the center of the Universe! The world population has doubled since the last grand commodities cycle. Much of the world’s population has increased their standards of living thus using more and more of the available resources. So we don’t even have hoarding in commodities to cause a huge price spike. The availability of additional resources is not only in question but in many cases under the control of unfriendly governments. This time we may not be able to increase production like in the past for many if not most commodities.
The US may have entered a slow down, but it is still very moderate. This cycle will be much bigger and longer than past cycles because the entire world is now one large neighborhood.
What this cycle means and does is reduce the quality of our currency. Last year you could buy a lot more with $100 than this year. Yet the debts taken on haven’t decreased. In many cases, they have actually increased. This is not just a US phenomenon. It maybe happening worse here than the rest of the world because of our total lack of fear and understanding of debt but we will see as this plays out. As the price of everything you need goes up and your income doesn’t, that means you either spend less or go further into debt. There is a point, which is being reached daily by more and more people, where incomes do not meet expenses and they either walk away from their home or go see an attorney and file for bankruptcy. This is the basis of the banking credit crisis. To much debt on over valued assets and to little income to pay that debt with.
Yet, this hasn’t slowed down the rising prices has it… Also know that the fed can create money out of thin air but they can not direct where it goes. All knowledgeable investment firms know the commodities cycle is still in its early stages. Maybe the fed is counting on this astute trading to bail out many of its friends but the consequences for the general economy will not be good.
I have said before, the Marie Antoinette Think Tank group is so disconnected from the reality of the average citizen that they have absolutely no idea what they are doing. Either that or they are just greedy evil narcissists.. Either way, they do not care one iota about you or your family. Period!
One thing I have been expecting, which has to happen at some point, I think it does, is investment house and hedge funds actually capitulating to the losses on all the bad loans they have on their books and the freezing of the financial system and selling everything they have to cover the losses and demands on them from their clients who have taken highly leveraged positions which have proved unprofitable as what Bear Sterns did. This won’t stop the commodities cycle. Could be a great place to buy in. If it happens.
I keep expecting this to happen but I may be wrong. All the Wall Street Institutions that made this mess may just get enough money from the fed to keep going and just carry all these bad debts in accounts off the balance sheets like the Japanese banks did. If this happens, then the commodity cycle will go into hyperbolic trajectory with all that newly created money and the US as we have known it for our entire lives will be ancient history.
Rising commodity prices are explained by one nation in the world: China, China, and China. If you put together all the nations of Southeast Asia, Africa, Middle East, Central Asia and Latin America, the industrial and population equilvalent is China. With the exception of oil, the Chinese economy is the world’s largest consumer of steel, copper, aluminum, tin, coal, zinc, lead, silver, cobalt, etc. Even Businessweek admitted in today’s issue, that the US subprime mortgage meltdown has absolutely no impact on the Chinese economic boom.
http://www.businessweek.com/globalbiz/content/mar2008/gb20080318_747713.htm?chan=top+news_top+news+index_global+business
Now comes the U.S. bear market and housing collapse. If you heap this looming U.S. recession onto the litany of China’s other woes does it spell a recipe for a total China meltdown? Don’t bet on it. In fact, analysts say that the question of decoupling—the notion that China is contagion free from a global slowdown—is actually a misnomer, since “historically, the Chinese economy has never been coupled,” says Jonathan Anderson, Asian chief economist at UBS.
The answer is that while China is widely viewed as an export powerhouse, selling everything from garden gnomes to laptop computers overseas, most of its economic growth is still fueled by domestic investment and consumption, neither of which has shown much sign of slowdown so far. Anderson reckons that China’s gross domestic product growth will slow to 10% this year, down from 11.4% in 2007, hardly the kind of slump to cause serious concern for Beijing.
The Chinese proclivity to sock away huge amounts of savings provides a further cushion to a downturn. That means the disturbingly high degree of leverage that got U.S. hedge funds and households into the subprime mess is a problem quite unknown in China where the minimum mortgage down payment is 30%.
The fundamental inflation-adjusted appreciation of commodities has everything to do with supply and demand: the development of India, China et. al coupled with resource-nationalization, land restrictions, two decades of underinvestment and bottlenecks up and down the supply chain. The same goes for both soft (ag) and hard (metals) commodities.
Frankel’s theory #3 is true but overlooks this main point. The prices of commodites ARE being impacted by speculation arising from lower rates and (more importantly) the falling dollar which results. But of course the fundamental reason for the current price increases is still supply and demand (w/out speculation, oil would still need to be well in excess of $70/bbl once you factor in production costs, exploration/development expense, royalties). Now historically, one could argue that interest rates had a greater impact upon commodities due to dollar fluctuations (since most commodities are priced in dollars)–but the current environment is very different.
Theories #1 and #2 are not wrong, but misconstrued: in a vacuum, of course an E&P would rather monetize their oil assets if rates are high. But that assumes there is sufficient demand worth the costs of production. No E&P company or mining firm calculates their resource-depletion strategies based on interest rates–decisions are made based on the costs of extraction weighed against the discounted value of future cash flows of existing resources, which in turn reflects supply/demand dynamics and yes, some speculation. To the extent interest rates either reflect or affect economic growth and thus supply/demand, then one can say that rates can correlate to commodities pricing. But to make a direct link is nonsensical: why would a high interest rate environment stimulate production unless there was corresponding demand for it? In the real world, higher interest rates would act as an inhibitor, as commodities extraction involves enormously high capital investment which translates into higher leverage/financial expenses–the company wouldn’t do it unless they were relatively certain of their return on capital.
So David Chiang,
You’re saying that the commodity boom will continue for the foreseeable future because even if the rest of the world slows down, China won’t. No matter how slow the US or the rest of the world’s economies get.
Of course that makes me even more uncomfortable about the future of my country. The outlook keeps looking less appetizing with higher and higher risk of conflict over resources in the future.
Plus a much deeper recession than anyone would like.
Prof Frankel does not take four key factors into account:
1) Many critical commodities are absolutely exhaustible resources: oil, natural gas, coal, and high-grade metal ores (including uranium).
2) Inventories of many commodities are not exactly high, according to the IEA and FAO. From the FAO page linked below.
“world cereal stocks by the close of the seasons ending in 2008 are expected to fall to just 405 million tonnes, down 22 million tonnes, or 5 percent, from their already reduced level at the start of the season and the smallest since 1982.”
3) In agreement with the previous post from David Chiang, Chinese economic growth, which was 11.4% in 2007, has already reached a point of self-sustainance, so that it would go on, although at a much lower rate, even in the face of a deep recession in OECD countries.
4) Repeating my post in the last thread, Chinese economic growth is much more energy-intensive (and resource-intensive in general) than that of OECD countries. China’s crude oil imports rose 12.3 percent in 2007. India goes second place, though at a distance
This issue was covered in the presentation at ASPO USA 2007 by Dr Vincent Matthews, Director of the Colorado Geological Survey:
http://www.aspousa.org/proceedings/houston/presentations/Vince%20Matthews%20China%20India1.pdf
And also by IEA chief economist Fatih Birol in his Nov 26 presentation of the World Energy Outlook 2007 to the CFR
http://www.cfr.org/publication/14888/ world_energy_outlook_2007_rush_transcript_federal_news_servi ce.html
“on the demand side, we see that the — China and India are transforming our energy markets by their sheer size. I’m going to give you some numbers about our projections for the future, but if you don’t believe our projections, which is completely legitimate — (scattered laughter) — you will see that in the last two years about 70 percent of the growth in global oil demand came from China plus India. About 80 percent on the global coal demand (growth, see below) came from these two countries”
“If you ask me, what is the most critical number assumption, I would tell you it is the pace and the nature of the Chinese economic growth. So it’s not only for our book, but for the oil markets, for climate change. It is very important how much China will grow and what kind of growth prospect they are going to follow.”
“China, according to our projections, will overtake the United States around 2010 as the largest energy consumer of the world. And just to put things in context, only in 2005 — two years ago — the U.S. was using 25 percent more energy than China. In around 2010, China will be overtaking the United States. And about 45 percent of the growth in the global energy demand will come from China, plus India. More than 80 percent of the growth from coal will come from these two countries.”
About energy and China, there is also an Oct 2007 report by Malcolm Shealy and James P. Dorian of CSIS, titled “Growing Chinese energy demand: is the world in denial?”
http://www.csis.org/component/option,com_csis_pubs/task,view/id,4150/
About the food situation, this recent article from Ban Ki-moon is eloquent
http://www.washingtonpost.com/wp-dyn/content/article/2008/03/11/AR2008031102462.html?hpid=opinionsbox1
while this FAO page give insight on specifics
http://www.fao.org/docrep/010/ah881e/ah881e04.htm
Finally, here’s my own contribution connecting energy, food, and the US current account balance: turning an ever greater share of US corn to ethanol (and then soybeans to biodiesel) can easily cause in a few years the halving of US agricultural exports in volume and their doubling at least in dollars (i.e. at least quadrupling agricultural prices). That will substantially reduce the US current account deficit and give the US a significant strategic advantage.
The US has certainly the right to follow that path. But they also have the duty to tell the world openly that they will do it. Like: “Along the coming years and decades our food exports will become progressively lower in volume, and the same will probably happen to total world food production. It is likely that they could be half their current volume in 10 years. People, and particularly poor people, should have it in mind when making procreation decisions.”
Dropping a nuke on a city is not genocide if its dwellers are given a week’s notice.
Higher commodity prices are not going to result in much new mine development until development becomes cheaper than acquiring new production assets on Wall Street. The mining companies huge cash flows are being diverted to acquiring Inco, Falconbridge, Phelps Dodge, Alcan, Lionore, Rio Tinto(?, Xstrada(?), at prices immediately accretive to earning, not massive new greenfield development. New supply response will not trigger until the share prices of mining companies rise to reflect current commodity prices.
Sadly I guess Prof. Frankel doesn’t deign to return to answer questions/counterpoints like Brad does.
Come home soon, Brad!
So many people seem to think they know what’s going on in the closed nation of China, a country that won’t let its people use the Internet. I’ll lay odds that most of what they think they know simply isn’t so. If you don’t believe your own gummints statistics, would you believe Chinas?
there is a very widespread misconception that the rise of industrial china and india drives the consumption of energy and commodities, and thus the price. does the jeep bring the diesel to the beach ? or does the diesel bring the jeep ?
it is of course the consumption of energy and commodities which drives the rise of china and india. completely remove chinese and indian emergence - and oil will still get consumed and command a price. completely remove oil and any industrial nation grinds to a halt.
one way to remove oil is to put the price beyond reach. as much as you want at $10 000 / bbl ? no one filling up the tank, today . . .
thus high commodity prices subvert demand, and subvert high commodity prices.
do lower interest rates boost commodity prices ?
it’s up to you. i suggest it depends upon the phase of the tulip mania -
interest rate zero - oil at $100 / bbl - how much do you wish to buy (a) if it was $75 last summer. (b) if it was $175 last summer ? and would zero interest rates deter you from shorting ?
of course all commodity markets can be distorted by people who actually consume the stuff. that is why tulip bulbs have rarely been bested as a bubble of great purity.
the central banks of the world could create a billion notional, digitally enhanced tulip bulbs - agree solemnly never to add to their number - and launch a tulip bulb ‘reserve currency’ for pure speculators alone. this would take the pressure of pro-cyclical speculation off commodity markets, perhaps.
why will they not do it ?
the transparency, the bright light shining in the gambling den, would be more than many people could bear.
.
Jeffrey,
I strongly recommend Robert Rapier’s piece on EROIE (Energy Returned on Invested Energy), which goes far further in understanding the rising price of oil than anything I have seen here. There are a number of resultant equations that economists might enjoy.
The era of “easy, cheap” oil is over. That is to say, more and more energy is being expended in its retrieval. For example, some claim that to produce two barrels of oil in the Canadian Tar Sands requires one barrel of oil. Or, to put it another way, the energy required to dig two barrels of oil requires the energy of one barrel of oil.
Imagine the energy required to build and extract oil from deep ocean floors.
Until economists have at least an inkling of the economic implications of EROIE, they will never have a handle on the rising cost of energy–as if everything is a matter of interest rates or monetary policy.
http://www.theoildrum.com/node/3707#more
Time for some real calculations.
Dr. Frankel’s theory isn’t inconsistent with what I suggested about global money supply growth well in access of GDP growth. Are you looking at a measure of real interest rates globally? After all, commodities are globally purchased
Its an interesting theory but if you look at the graph which is supposed to at least support the theory it obviously does not. Without the three data points at the top left the regression line would be flat to my eye and even if it were tilted one way or another the dispersion around it would make it useless anyways.
Or put it another way, if you walked a model such as this around wall street trying to raise capital for a commodity fund, I don’t think you would get very far.
The best models I have ever seen for predicting commodities prices are the historical prices, historical carrying costs and open interest in trading contracts. Of course these models never make it into any academic publication and are never studied as such because they are used to manage money.
There is probably a pretty interesting paper to be written about how information dissemination can be retarded because the information has great value. I suppose that someone has already done something of the sort with regards to patents and the like.
Now that is what I call a loose fit to a regression line. If you were to just eyeball that scatter plot without the line drawn in how many people would draw the line as it appears here? R squared really low on that one - time for a model that actually explains the variance a bit better dont you think?
In fact, analysts say that the question of decoupling—the notion that China is contagion free from a global slowdown—is actually a misnomer, since “historically, the Chinese economy has never been coupled,” says Jonathan Anderson, Asian chief economist at UBS.
It is absolutely false to pose this in terms of _either_ coupled _or_ decoupled when what requires understanding are degrees and forms of relationship within the context of centuries of world change. When this is done, our many ‘centrisms’ and associated falsifications began to stand out. As partial antidote, Jonathan Anderson may want to read the late A. G. Frank’s ReOrient: Global Economy in the Asian Age.
If JF is arguing an interaction between real interest rate (which rate?) and differential rates of return among asset classes, it may have some weight but to the extent what is being traded, claims, is ignored in favor of a type of purely physical efficient market notion (as though futures’ trade is not open to speculative pressures and their associated justifications), that weight is diminished.
Oh, ‘easy, cheap’ is dependent on more than geology but also changing E&P and refining technologies which, unlike an ‘energy theory of value’, have more to do with the economics of capitalism such as rate of profit.
“We’re seeing an annual decline rate in oil production of roughly 6 million barrels per day. Russia, which has been responsible for much of the new production offsetting the decline rate, is now also in decline. Angola, another major source of new production, has just gone flat. Saudi Arabia is pumping about all it can sustainably pump.
Moe”
Written by Anonymous on 2008-03-18 12:01:31
This is what happens when demand falls.
Demand sometimes falls when prices rise.
The base demand may be inelastic to a degree, but there is also plenty of price sensitive demand.
You can see this with your own eyes where I live.
Do you seriously think producers can keep pumping into a glutted market.
There is no shortage of crude.
Fund investment is setting the price, not demand.
It’s a bubble.
prices rise because of debt based money supply. As soon as money starts to be destroyed in huge numbers, commodity prices will fall like the rest.