CAMBRIDGE – Oil prices have plummeted 40%
since June – good news for oil-importing countries, but bad news for Russia,
Venezuela, Nigeria, and other oil exporters. Some attribute the price drop to
the US
shale-energy boom. Others cite OPEC’s failure to agree on supply
restrictions.
But that is not the whole story. The price of
iron ore is down, too. So are gold, silver, and platinum prices. And the same
is true of sugar, cotton, and soybean prices. In fact, most dollar commodity
prices have fallen since the first half of the year. Though a host of
sector-specific factors affect the price of each commodity, the fact that the
downswing is so broad – as is often the case with big price swings – suggests
that macroeconomic factors are at work.
So, what macroeconomic factors could be
driving down commodity prices? Perhaps it is deflation. But, though inflation
is very low, and even negative in a few countries, something more must be going
on, because commodity prices are falling relative to the overall price level.
In other words, real commodity prices are falling.
The most common explanation is the global
economic slowdown, which has diminished demand for energy, minerals, and
agricultural products. Indeed, growth has slowed and GDP forecasts have been revised downward since mid-year in most countries.
But the United States is a major exception.
The American expansion seems increasingly well established, with estimated
annual growth exceeding 4% over the last two quarters. And yet it is
particularly in the US that commodity prices have been falling. The
Economist’s euro-denominated Commodity Price Index, for example, has actually risen
over the last year; it is only the Index in terms of dollars – which is what
gets all of the attention – that is down.
That brings us to monetary policy, the
importance of which as a determinant of commodity prices is often forgotten.
Monetary tightening is widely anticipated in the US, with the Federal Reserve
having ended quantitative easing in October and likely to raise short-term
interest rates sometime in the coming year.
This recalls a familiar
historical pattern. Falling real (inflation-adjusted) interest rates in the
1970s, 2002-2004, and 2007-2008 were accompanied by rising real
commodity prices; sharp increases in US real interest rates in the 1980s sent dollar commodity prices tumbling.
There is something intuitive about the idea
that when the Fed “prints money,” the money flows into commodities, among other
places, and so bids their prices up – and thus that prices fall when interest
rates rise. But, what, exactly, is the causal mechanism?
In fact, there are four channels through which the real interest rate affects
real commodity prices (aside from whatever effect it has via the level of
economic activity). First, high interest rates reduce the price of storable commodities by increasing the
incentive for extraction today rather than tomorrow, thereby boosting the pace
at which oil is pumped, gold is mined, or forests are logged.
Second, high
rates also decrease firms’ desire to carry inventories (think of oil held in tanks).
Third, portfolio managers respond to a rise
in interest rates by shifting out of commodity contracts (which are now an
“asset class”) and into treasury bills. Finally, high interest rates strengthen
the domestic currency, thereby reducing the price of internationally traded commodities in
domestic terms (even if the price has not fallen in foreign-currency terms).
US interest rates did not really rise in
2014, so most of these mechanisms are not yet directly at work. But speculators
are thinking ahead and shifting out of commodities today in anticipation of
future higher interest rates in 2015; the result has been to bring next year’s
price increase forward to today.
The fourth of the channels, the exchange
rate, has already been functioning. The prospect of US monetary tightening
coincides with moves by the European Central Bank and the Bank of Japan toward
enhanced monetary stimulus. The result has been an appreciation of the dollar
against the euro and the yen. The euro is down 8% against the dollar since the
first half of the year and the yen is down 14%. That explains how so many
commodity prices can be down in terms of dollars and up in terms of other
currencies.
Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government, previously served as a member of President Bill Clinton’s Council of Economic Advisers. He directs the Program in International Finance and Macroeconomics at the US National Bureau of Economic Research, where he is a member of the Business Cycle Dating Committee, the official US arbiter of recession and recovery.
