The Effect of Interest Rates on Commodity Prices  

Jeffrey Frankel, Kennedy School of Government, Harvard University

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, Dec. 2006.  Revised version of  “Commodity Prices, Monetary Policy, and Currency Regimes,”  May 2006. 

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.

The mechanisms: 

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 from August  2007 to September 2008.  Call it an example of the "carry trade."

Media coverage of this idea         

    In Blogs
         "I Got Your Oil Inventories Right Here" Economics of Contempt, May 29
            "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
   
    In Newspapers

"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.

High Oil Prices Spur Thoughts About Bubbles, But This Might Be Misguided," Wall Street Journal, May 27, 2008, p.A5
"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.
 

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 graph of log real commodity price index versus short-term real interest rate (1950-2005)

(Thanks to Research Assistant Ellis Connolly.)

The relationship is statistically significant.  Regression results are available, as are tests with alternative indices from Reuters and Goldman Sachs (thanks to RA. Maral.Shamloo).       Updated in  "Commodity Prices and Monetary Policy, 2006" .

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 have accelerated (see graph)-- undercutting that theory.
           Recent developments instead support 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..."

    Update, 2009

In mid 2008, prices of oil and most other minerals peaked.   Over the subsequent year they have come down as sharply as they had gone up.   The obvious explanation is the acceleration of the financial crisis (associated with the default of Lehman Brothers) and the onset of global recession.    If my point about the positive effect of low real interest rates is correct, it has during this period been overwhelmed by the negative effect of the weak economy.   (The equation has both macroeconomic factors in it.)

    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 (in the Middle East, Russia, Nigeria, and Venezuela) pushed up oil prices before 2008.  Drought in Australia and ethanol subsidies in the US boosted grain prices.  Such effects in individual commodities 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 most recent paper on the subject uses those variables, along with inventories, to determine commodity prices:

NEW  "Determination of Agricultural and Mineral Commodity Prices" (co-authored with Andy rose) second draft,  presented at  Inflation in an Era of Relative Price Shocks, a conference  at the Reserve Bank of Australia, August 2009. 3rd draft.    Data.    “Determination of Prices of Agricultural and Mineral Commodities,” first draft presented at pre-conference June 16-17, 2009, Muenster, Germany.  

      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.

 

Causality runs not just from monetary conditions to commodity prices, but the other direction as well:

See  Webpage on proposal that monetary authorities in small countries should Peg the Export Price (PEP), instead of targeting the exchange rate or CPI.

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