Commodities and the Fed: Answering the Skeptics

Judging from some of the reactions across the blogosphere (not to mention any number of our own dear readers), maybe I should take another stab at clarifying why I see the hand of the Federal Reserve in the most recent movements in oil and commodity prices.

Let's start with Free Exchange, who had this to say:

JAMES HAMILTON is an excellent economist and blogger [thank you kindly], but he's confounded me today. In a post examining the roots of the recent surge in oil prices, Mr Hamilton displays a number of charts which seem to clearly indicate the extent to which petroleum production has stagnated-- not just in recent months, but over the past few years-- even as global demand growth has proceeded apace. He then goes on to note that this has practically nothing to do with increases in oil prices.

Then please permit me this opportunity to clarify. Stagnating oil production in the face of strong demand has everything to do with the broad run-up in oil prices since 2001, as we've been saying over and over from the very beginning of this blog. My claim that the Federal Reserve has now also started to contribute to the most recent oil price increases is very specific to what we've observed since January of this year, as I clarified when I first raised this issue February 28:

Although I have been skeptical of Jeff Frankel's story that low interest rates were the primary cause of the broad movements in commodity prices over the last several years, it is very plausible to me as one explanation of what we've seen happen over the last two months.

And here's what I said on March 28:

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 ([1], [2]) 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.

Paul Krugman, Lawrance Lux, and two Angry Bears are also skeptical of my claims. Some weeks back Paul noted that, if commodity speculation is playing a role in price moves, we should be seeing inventory accumulation. He appealed to a diagram such as the one below, which depicts the supply and demand curve in the absence of any inventory changes or speculation. Krugman noted that if speculation succeeded in driving the price above the fundamentals equilibrium price P0, it would produce a gap between supply and demand, and would have to show up as inventory accumulation.

But where, Paul asked, is the current evidence of that inventory accumulation? On Sunday, he answered his own question with this graph of metals inventories:

But again, I agree with Paul and the others above that speculation was not the primary factor prior to January, and I draw the same conclusion they do from the historical graph. But in terms of interpreting the trends over the last few months, let me just note that the very short run supply and demand curves for most of these commodities are extremely steep-- there is practically no way to bring more copper to the market over the next few weeks unless you are bringing it out of storage somewhere. And if those curves are extremely steep, the magnitude of the inventory change you'd expect would be quite small. Particularly since it could show up anywhere in the chain from production to consumption, I don't think there's a strong presumption you could find evidence of it in the available data.

No matter what your favorite explanation might be-- whether speculation or fundamentals of supply or demand-- any coherent theory says these shifts should show up somewhere in quantities produced, consumed, or stored. But given the very low short-run supply and demand elasticities and the quality of available data, hoping to find confirmation or refutation of that theory on the basis of the quantity data may be asking too much. I believe we have to rely on something else to persuade us. And the main thing that makes me doubt the demand-based story is the fact that the latest surge in commodity prices-- that since January-- came at a time when every indicator of which I'm aware pointed to slower rather than faster real economic growth.

The Free Exchange piece quoted above ends up with the following conclusion:

I predict that if the Fed did surprise by holding the rate steady, oil might crash--all the way back to $100 per barrel.

Again, that's not so different from my own views. Except that I'd add that $100 a barrel would be a welcome development at the moment. If it's within the Fed's power to achieve that, the opportunity should be seized with enthusiasm.

Comments

[buyitcheap]

I agree with this assessment. Could we see a round of global rate increases to ring out this speculative commodity bubble? That said, if the fed did hold, and we already have late planting forecast in the midwest due to bad weather, all we need is a minor blight or dry summer to marginally reduce the yields, and prices could continue to climb. Absent a rate INCREASE, commodities have that "priced for perfection" feel to them, where any disruption will result in an immediate spike up.

[Will Rahal]

Surging Economies such as India and China are generating an unprecedented demand for commodities as workers get richer.
Just picture, say, 300 million people dropping their bikes and picking up a motorcycle or small car. If they use 2-3 gallons gasoline/week ... you get the picture
I have posted charts of ratios between Crude, Intermediate & Finished Goods.
These ratios are at extreme, pointing to an imminent correction in commodities. See
wrahal.blogspot.com/20...

[surgcare]

I am no genius but DAH this stuff is common sense . People aren;t rioting around the world because there's excess food . Wake up

[Shalom Hamou]

<p><b>The Commodity Conundrum Solved <br><br>Th... Hidden Parameter in
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When the yield curve is inverted, because of profit maximization, Miners and Drillers, as a group, prefer hoarding a higher proportion of their minerals in the ground (their preferred short-term assets) rather than extract them and invest the proceeds in long-term instruments.

<br><br>He... the marginal cost of extraction of minerals becomes irrelevant to their market price as miners stop maximizing their output under the constraint:

<br><br>&l... Price - Their Marginal Cost of Extraction > 0</b>

<br><br>Re... the Marginal Cost of Extraction does not include fixed cost (i.e. exploration cost, cost of an offshore platform...) <br><br>Th... quality of the
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[ignorant]

Why would speculative behavior have to be reflected in inventory builds? If speculators are using futures contracts and continually rolling over the contracts and adding new contracts month to month prices would increase with no inventory build?

[e2800]

Speculation has almost everything to do with the recent price run up. Have you checked the volume. I have traded CL futures for about 3 years and up until about 4 months ago the highest volume in any 5 min bar on the electronic exchange was roughly 4000 to 5000 contracts. Recently that volume is now spiking to 8000 to 10000, and on 1 recent supply report volume was 16000 contracts. You want to tell me that is a coincidence? As for the increase in supply issue, too many economists get caught in models and theories and forget real life. In the futures markets the commercials are net short. They are not going to be filling their tanks at these prices when they believe the prices are inflated. I know I don't fill my tank, I purchase just what I need. Even if I'm paying $15.00 this week and $14.75 last week, I rather have the other $50.00 to use on something else rather than sitting in my tank. At some point the theories and models lose out to practicality and common sense.
There is no need for a refiner to have anymore inventory than is necessary at these prices.

[CommodityBubbleproponent]

This argument is nonsense. The reason we don't have inventory buildups is that negative real interest rates encourage people to use the inventory rather than produce out of mines or invest in new capacity. Benny & His buddies at the fed have now firmly ingrained high inflation expectations into commodity producers minds
Why sell your copper at $3.75/oz when you know it will be worth $4.25 tomorrow?

This is why nobody wants to invest in new production. It makes more economic sense to keep the reserves in the ground. We need interest rate hikes to reverse this