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January 7, 2011
EDMONTON, AB, Jan. 7, 2011/ Troy Media/ – With the exception of natural gas, commodity prices have been surging over the past half year – especially crude oil. Insatiable demand from China, poor weather in Central Asia and an influx of institutional investors (i.e. speculators) are factors often cited to explain the broad rise in commodity prices.
While commodities tend to be amongst the first to rebound after a recession, how can this continue with persistently poor growth numbers in most advanced economies? What if prices are overshooting fundamentals as a result of monetary policy?
Overshooting the fundamentals
A well-known paper on the linkages between monetary policy and commodity prices was written back in the 1980s by a prominent economist, Dr. Jeffrey Frankel, who currently teaches at Harvard. In the paper Dr. Frankel formalized why it’s perfectly rational for commodities to ‘overshoot’ their fundamentals in response to monetary policy shocks because:
1) commodity prices move quickly (both higher and lower);
2) commodities are storable assets; and
3) prices for all goods and services in an economy are expected to, in the long-run, grow at the same pace as the money supply.
How those three observations combine to give the result that commodity prices often overshoot fundaments isn’t readily intuitive. Commodity prices are set on exchanges where they change instantly to new information (other prices take considerable time to adjust), like changes in monetary policy. Shocks to the money supply are intended to influence the interest rate. Interest rates impact the pace at which commodities are maximally exploited, which is at the point where the rate of price appreciation in the commodity asset (adjusted for storage costs) equals the going interest rate on other assets.
In the long-run, other prices in the economy eventually adjust (inflate) to the new growth-rate in the money supply; commodity prices just adjust earlier (hence the overshooting of fundamentals).
The key point in Frankel’s model is the ability of commodity prices to adjust quickly today, such that the net expected future investment return to the owners of the resource approximates the return on other investments (of interest is where commodity prices are going, not where they are today). If this doesn’t hold, a classic arbitrage opportunity exists. Reinforcing the linkage is the fact that the financing of storage costs, which directly impacts the net-return, is also inversely related to interest rate costs. It takes time for other markets to adjust to the new growth rate in the money supply but, as they do, the economy rebalances – just at a new higher price level (so commodity prices don’t actually dip after spiking, they just increase quicker then other prices in the economy).
Frankel doesn’t claim that his model explains individual commodity prices (as individual commodity prices are influenced by various unique factors, such as higher extraction costs and weather), but he does offer statistics to support the contention that, in aggregate, commodity prices are inversely related to interest rates. For instance, in the 80s the real interest rate was at historically high levels while commodity prices were low and during the 70s and 2000s, when the real interest rate was low, commodity prices were high. The monetary policy effect on prices can then be thought of accentuating commodity price movements.
Maintaining speculative positions
Institutional commodity investors weren’t very active in the commodities market in the 80s when Frankel formulated his model, but he’s been quick to point out in recent commentary that institutional investors have probably accentuate the linkage between monetary policy and commodity prices. Institutional investors, however, wouldn’t likely be modeled in the same fashion, as the impact of leverage would have to be included. That is to say, the lower interest rates make it far easier for them to maintain speculative positions.
Whether or not commodities are overshooting is partially an academic exercise. Dr. Frankel makes a strong case for why the policy actions taken by the U.S. Federal Reserve should result in high commodity prices. It might not reflect the market perfectly, but it certainly provides some food for thought.
Will Van’t Veld is an economist with ATB Financial.