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Is the Fed starting to get it? Financialization of commodities has them handcuffed.

It's pretty clear that the major impacts from QE2 were on the dollar and commodities.  While Bernanke's Fed understood the dollar impact, it's pretty clear he was working on an old model with respect to commodity markets.  The game has changed. 

Institutional changes have effectively eliminated position limits in futures markets, so investment flows now dominate price movements, not the fundamentals.  OTC swaps and ETFs, based on futures contracts, allow investors to directly bet on commodity price changes; and the big institutions that sell these investments are viewed as hedgers, so position limits are less restrictive now. 

A combination of the financialization of commodities, low yields in other asset classes, and a widespread misunderstanding of the money-price transmission mechanism (vestiges of Milton Friedman's influence) meant QE2 was dead on arrival. 

The old transmission mechanism from expansionary monetary policy to prices was indirect.  As the Fed bought bonds, interest rates would fall, and investors would reallocate funds into equities. The lower interest rates were supposed to stimulate the economy by increasing investment spending and narrowing the trade deficit from a lower dollar.  In addition, higher equity prices would stimulate consumption from a wealth effect as well as improve confidence. Any impact on prices would be indirect from increased aggregate demand.  This was before commodities became an asset class.

Since investors believed QE2 was "money printing" and therefore inflationary (Friedman's influence), the main portfolio effect has been the push into commodities.  The financialization of commodities has created a direct link between monetary policy and commodity prices, and therefore inflation.  The Fed is handcuffed. 

If they try to prick the commodity bubble with higher interest rates, they put the economic recovery at risk; if they maintain policy, they stoke the commodity bubble, which also puts the economy at risk.  Talk about a rock and a hard place...


Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.