Last week we received some new data linking commodity prices to the decisions of the U.S. Federal Reserve.
I have long argued that the broad increase in commodity prices over the last five years has primarily been driven by strong global demand. But I am equally persuaded that the phenomenal increase (,
) in the price of virtually every storable commodity in January and February cannot be due to those same forces. This was a period when the economic news was getting bleaker by the day, eventually persuading many of us that a recession has likely started. To argue that January and February’s news instead signaled booming commodity demand strains credulity.
Nor do I agree with those who attribute the recent commodity price increases primarily to the falling value of the dollar. True, the dollar price of an internationally traded commodity should rise when the dollar falls. But the dollar only depreciated 7% against the euro between January 1 and March 17, while the average commodity included in the table at the right gained more than twice that. You paid more for your aluminum and coffee and wheat regardless of whether you tried to pay with dollars or euros or yen.
|Jan 1- Mar 17||Mar 17 – Mar 20|
|$ per euro||+7.0||-2.2|
|April fed funds||-1.91||+0.22|
Instead I believe that Harvard Professor Jeff Frankel has the correct explanation– commodity prices at the moment are being driven by interest rates, with a strongly negative real interest rate increasing the incentives for speculation in any storable commodity.
A simple efficient markets view suggests that the price of a storable commodity on any given day already incorporates expectations of foreseeable future developments, in which case the change in price would be driven by unanticipated news. One of the biggest surprises of the new year was how quickly the Federal Reserve lowered interest rates. For example, on December 31, the CBOT fed funds futures contract implied an expected fed funds rate of 3.855% for the month of April. By March 17, that expected April rate had fallen to 1.945%, a phenomenal drop of 191 basis points within the space of less than three months. These revisions in expectations of Fed policy coincided quite precisely with the boom in commodity prices over that period.
However, at its March 18 meeting, the Fed surprised the markets, dropping its target for the fed funds rate by “only” 75 basis points, with dissents within the FOMC about whether they should even go that far. The market had expected a bigger cut, and the expected interest rate implied by the April fed funds futures contract shot back up on the news to 2.165%, a 22 basis point gain.
It’s interesting to note how dramatically commodity prices responded to the news that the April interest rate was going to be higher than markets had been anticipating. In the days since the FOMC meeting, the average commodity in the table above has fallen 8% in value.
I had urged even more restraint for the Fed at its March 18 meeting, in which case I have every confidence that the numbers in the table above would have been even more dramatic. Even so, it seems pretty hard to look at these data and conclude that the Federal Reserve has not been a major factor driving commodity prices over the last few months.
Why does it matter? Swings in relative prices of this magnitude are destabilizing. The Fed would like to stimulate more, but it also has to be realistic about what it is capable of accomplishing through manipulation of the fed funds target. Bernanke also needs to be mindful that one of his most valuable assets, if he hopes to be able to accomplish anything through adjustments of the fed funds rate, is the confidence on the part of the public in the Fed’s long-run inflation-fighting resolve.