Effect of Interest Rates on Commodity Prices
Jeffrey Frankel, Harvard University
|The central claim||The mechanisms||Press coverage of the idea||The overshooting theory||Graphs||Update & other influences on commodity prices|
The central claim:
Real interest rates are an important influence on real prices of mineral and agricultural commodities.
"The Effect of Monetary Policy on Real Commodity Prices" in Asset Prices and Monetary Policy, John Campbell, ed., U.Chicago Press, 2008: 291-327. NBER WP 12713.
The argument is summarized briefly in:
"Monetary Policy and Commodity Prices," Vox, May 29, 2008; or "Fed Modesty Regarding Its Role in Commodity Prices," Jeff Frankel's blog, May 21, 2008.
And "An Explanation for Soaring Commodity Prices," Vox, March 25, 2008. Or “Real Rates Key to Commodity Prices,” Reuters.com, March 19, 2008.
And in "The Impact of Monetary Policy on Commodity Prices," Monetary Policy Review.
High interest rates reduce the price of storable commodities through four 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 commodity contracts, and into treasury bills
¤ by appreciating the domestic currency and so reducing the price of internationally traded commodities in domestic terms (even if the price hasn't fallen in terms of foreign currency).
All four mechanisms work to reduce the real 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 2007-08 and 2010-11. Call it an example of the "carry trade."
coverage of this idea
In Newspapers/ Print Media
“Commodity Prices and Interest Rates,” Economic Outlook (CoBank), Oct. 2012, vol.9, no. 10, pp.1-6.
“Bernanke feels pressure of nation’s rising oil gauge," Financial Times, Sept.2, 2011. pdf photocopy.
"High Oil Prices Spur Thoughts About Bubbles, But This Might Be Misguided," Wall Street Journal, May 27, 2008, p.A5.
Op-ed: "Why Are Oil and Metal Prices High? Don’t Forget Low Interest Rates," published as "Real Interest Rates Cast a Shadow Over Oil," Financial Times, April 15, 2005.
"Mr. Greenspan's Strategic Reserve," The Dismal Science, Susan Lee, Wall Street Journal, Mon. Sept. 20, 2004, p. A21
"Too much money to blame for rising price of oil, economists claim," Anna Fifield, Financial Times, Sept. 18, 2004.
"More to oil shocks than Middle East," Charles Clover and Anna Fifield, Financial Times, July 29, 2004.
"Does the Debt Crisis Signal the End of the Mining Boom," Thebull.com.au, Jan.19, 2012.
"I Got Your Oil Inventories Right Here" Economics of Contempt, May 29, 2008
"What's Online" New York Times, March 29, 2008.
"Why Commodity Prices are High," Alhambra Investment Management, March 29.
Market Blog, March 27, 2008.
"Would you like anything else with that coffee, Ben?" EconBrowser, March 26.
Mike's Economic Blog, March 26, 2008.
"A Solution of Sorts," Greg Mankiw's blog, March 20, 2008.
"Commodity Prices," Paul Krugman's blog, March 19.
Naked Capitalism, March 19.
Freedom Forum, March 19, 2008.
TransEconomics, March 18.
Angry Bear, March 18.
Secondary Sources, Wall St. Journal, March 18, 2008.
"The delinking of world growth and commodity price inflation," The Bayesian Heresy, March 16.
"Commodity Prices and the Fed," Economist Blog, March 7, 2008.
"The Next Big Bubble," Macro & Other Market Musings, Feb. 21, 2008
The Stalwart, Jan 26, 2008.
"Is US monetary policy behind the surge in commodity prices?" Jim Hamilton blog, Jan.25
The overshooting theory
The theoretical model can be summarized as follows. A monetary contraction temporarily raises the real interest rate (whether via a rise in the nominal interest rate, a fall in expected inflation, or both). Real commodity prices fall. How far? Until commodities are widely considered "undervalued" -- so undervalued that there is an expectation of future appreciation (together with other advantages of holding inventories, namely the "convenience yield") that is sufficient to offset the higher interest rate (and other costs of carrying inventories: storage costs plus any risk premium). Only then are firms willing to hold the inventories despite the high 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.
See: "Expectations and Commodity Price Dynamics: The Overshooting Model," American Journal of Agricultural Economics 68, no. 2, May 1986, 344-348. Reprinted in Financial Markets and Monetary Policy, MIT Press, 1995.
The deep reason for the overshooting phenomenon is that agricultural and mineral prices adjust rapidly, while most other prices adjust slowly.
See: "Commodity Prices and Money: Lessons from International Finance," American J. of Agricultural Economics 66, no. 5, Dec. 1984, 560-66.
Simple graphs of real commodity price index versus short-term real interest rate
Real commodity prices (in $) have been negatively correlated with the real 3-month T-bill rate.
The relationship is statistically significant. Regression results for 1950-2012 are available (as are tests with alternative indices from CRB, Dow Jones, Reuters & Goldman Sachs) thanks to R.A. Marco Martinez del Angel.
Earlier versions are available for 1951-2007 from "Increases in Global Commodity Prices," (thanks to A.Saiki); and for 1950-2003 (thanks to RA M.Shamloo). Also in "Commodity Prices and Monetary Policy," 2006.
spikes in the 1970s, 2008 & 2011 can be explained by real interest rates that
are zero or even negative.
Update, and other influences on commodity prices
Update: April 2008
The dominant macroeconomic explanation for the 2001-07 run-up in commodity prices had been strong real growth in the world economy.
But after August 2007 growth slowed worldwide, yet commodity prices accelerated (see graph)-- undercutting that theory.
That episode supported the importance of declining real interest rates, as argued here. King Abdullah of Saudi Arabia, for one,
apparently believed that the rate of return on oil reserves was higher if he didn't pump than if he did. On April 12, 2008, he said
"Let them remain in the ground for our children and grandchildren..."
Prices of oil and most other minerals peaked in mid-2008. Over the subsequent year they came down sharply. The obvious explanation was the financial crisis and the onset of global recession.
If my point about the positive effect of low real interest rates is correct, it was during this period overwhelmed by the negative effect of the weak economy. (The equation has both macroeconomic factors in it.)
The big new upsurge in commodity prices over the last two years again fits the story, as US interest rates fell virtually to zero.
Non-macroeconomic factors matter too
Of course many other things beyond real interest rates and growth influence commodity prices. Booming demand from China and feared supply disruptions have pushed up oil prices in recent years.. Such effects on individual commodities as Australian floods, Russian droughts or US ethanol subsidies, partially average out when looking at a basket average of commodity prices, which is one reason aggregate indices were used in the graphs reported above.
Controlling for other factors
One way to control for other factors is to employ measures of convenience yield and risk among producing countries in the regression equation that determines inventory holdings. My recent papers on the subject uses those variables, along with inventories, to determine commodity prices:
"Determination of Agricultural and Mineral Commodity Prices," with Andrew Rose, Chapter 1 in Inflation in an Era of Relative Price Shocks (Reserve Bank of Australia: Sydney), 2010: pp. 9-51. Data.
HKS RWP 10-038. Conference at the RBA, Aug. 2009; 3rd draft. 1st draft presented at pre-conference, June 2009, Muenster, Germany.
Video of session on forecasting commodity prices. "Estimated Effects of Speculation and Interest Rates in a “Carry Trade” Model of Commodity Prices," March 2013. Presented at Conference on Understanding International Commodity Price Fluctuations, organized by the IMF Research Department and the Oxford Centre for the Analysis of Resource Rich Economies at Oxford University, March 20-21, 2013, Washington, D.C.
Another way of isolating the macroeconomic effects on commodity prices is to look at jumps in financial market prices that occur in immediate response to government announcements that change perceptions of monetary policy, as was true of Fed money supply announcements in the early 1980s. Money announcements that caused interest rates to jump up would on average cause commodity prices to fall, and vice versa. The experiment is interesting, because news regarding supply disruptions and so forth is unlikely to have come out during the short time intervals in question.
See: "Commodity Prices, Money Surprises, and Fed Credibility," with Gikas Hardouvelis, Journal of Money, Credit and Banking 17, no. 4, Nov.1985, Part I), 427-438. Reprinted in Financial Markets and Monetary Policy (MIT Press), 1995.
Other research deals with
effects of commodity prices,
especially in exporting countries, as
opposed to causes.