How Real Interest Rates Cast a Shadow Over Oil

April 15, 2005
Jeffrey Frankel

Financial Times

There are plenty of explanations for the high real price of oil over the last few years. Production in the Persian Gulf may be running into new limits; some other oil producers have experienced political uncertainty; and demand from some countries (particularly China and the US) has risen faster than anticipated. But this is unlikely to be the complete explanation. Prices of other mineral products - aluminium, copper, zinc - are also very high. In fact, some indices have hit 25-year peaks recently. This is probably not a pure coincidence. For one thing, if an unexpected surge in final demand were the explanation, companies would be holding levels of inventories lower than they are currently holding.

Low real interest rates arising from easy US monetary policy are one factor that has not received enough attention. Everyone saw in the 1970s that excessively expansionary monetary policy raised nominal prices of commodities. But here we are talking about real prices of mineral commodities - that is, prices of mineral commodities relative to the general price level.

How does monetary policy influence real commodity prices? An increase in real interest rates reduces the demand for storable commodities, or increases the supply, in various ways: by increasing the incentive for extraction today rather than tomorrow (think of the rate at which oil is pumped); by decreasing companies' desire to carry higher than usual inventories; or by encouraging speculators to shift out of spot commodity contracts and into Treasury bills.

All three mechanisms work to reduce the market prices of mineral commodities, as happened when real interest rates were high in the early 1980s. A decrease in real interest rates, as between 2001 and 2004, has the opposite effect - it raises commodity prices by decreasing the incentive for extraction, lowering the cost of carrying inventories and encouraging speculators to shift into commodity contracts.

This approach can be supported both by theory and by historical statistics. The theoretical model 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. The deep reason for the overshooting phenomenon is that prices for mineral and agricultural products adjust rapidly, while most other prices adjust slowly.

The process can be summarised as follows. A monetary contraction temporarily raises the real interest rate (via a rise in the nominal interest rate, a fall in expected inflation, or both). Real commodity prices fall until the commodities are widely considered "undervalued" - so undervalued that there is an expectation of future appreciation sufficient to offset the higher interest rate and other costs of carrying inventories. Only then are companies 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 originally.

The simplest way of demonstrating statistical support for the theory is to show the historical correlation between the short-term real interest rate and a real index of commodity prices (http:// ksghome.harvard.edu/jfrankel/CP.htm). The correlation is statistically significant over the period from 1970 to 2003, regardless of the commodity price index one looks at.

The Federal Reserve disagrees with the view that commodity prices reflect monetary policy. Its sensitivity is understandable. It is worried that if the overshooting interpretation of current high commodity prices is right, it may imply that expectations of inflation have been rising. But the sensitivity is probably not necessary. The decline in real interest rates relative to 2001 has consisted primarily of a fall in nominal interest rates, rather than a rise in expected inflation.

There are lots of influences on oil prices apart from real interest rates, including supply limits, political uncertainty and Chinese demand. Other individual commodities are influenced by factors of their own, weather, technology and so on. Such effects partially average out when a basket of commodity prices is used, which is one reason to look at aggregate indices.

One implication of this view is that the Fed's continued action to increase short-term interest rates this year and move them back towards a neutral setting could eventually dampen real commodity prices. In other words, it is not just real estate, junk bonds and emerging market debt that are vulnerable. Commodities are, too.

Jeffrey Frankel is a professor at Harvard University's Kennedy School of Government.

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