May 4, 2008

The Economist: Bernanke's Bind

An important article in this week's Economist. As I had first pointed out a couple weeks ago on my new blog, part of the reason for the rising inflation in commodity prices, such as oil and rice has been due to the combination of dollar-denominated commodity prices and a weakening U.S. dollar; i.e., as the dollar weakens against other currencies, this causes the prices for commodities to rise in order to maintain value. (For you non-Econogeeks out there, this is what is known as "purchasing power parity." A McDonald's Big Mac here in Singapore is the same as a Big Mac in the U.S., and the exchange rate between the Singapore and U.S. dollars should be such that you would pay the same amount for the same product (the Big Mac) regardless of what currency you're using.)

The other major problem is that, as interest rates keep going down (as they did again last week), the real value of the interest rate goes into negative territory. The real interest rate is (essentially) the nominal interest rate minus the rate of inflation. With this negative real interest rate, commodity producers such as farmers, miners, oilers, etc., have more incentive not to sell their products, even though this hurts them in the short-term by not bringing in revenue. As a a result, the amount of supply is lowered, which, in turn, raises prices.

There is another problem mentioned in the final paragraph below; however, the primary argument remains that the Federal Reserve must take some share of the blame for rising commodity prices, whether it's oil or agricultural products, due to their continued lowering of interest rates. This argument suggests, then, that commodity prices might not begin to drop until the U.S. dollar starts to strengthen.

An excerpt from the article:

But oil—and other commodities—are the crux of the problem. In the past, economic weakness in America has usually pushed the price of oil and other commodities down. That relationship has weakened thanks to demand growth in big commodity-intensive emerging economies. But the recent surprise is that commodity prices have soared even as America’s economy has stalled and forecasts for global growth have been trimmed as well. Supply shocks are clearly part of the problem. But the fact that prices have soared across so many commodities suggests a common cause.

Could the culprit be the Fed? Advocates of this idea point to two channels. First, by slashing real interest rates, the Fed has encouraged speculation in commodities by reducing the cost of holding inventories. Second, by pushing down the dollar, Fed looseness is pushing up the price of dollar-denominated commodities.

Jeff Frankel, a Harvard economist, has long argued that low real interest rates lead to higher commodity prices. When real rates fall, he points out, commodity producers have more incentive to keep their asset—whether crude oil, gold or grain—in the ground or in a silo, than to sell today. Speculators, in turn, have more incentive to shift into commodities. There is no doubt that commodities have become an increasingly popular investment category—in fact they bear many of the hallmarks of a speculative bubble. But inventories for many commodities, particularly grains, are unusually low.

What about the dollar link? Chakib Khelil, president of the Organisation of Petroleum - Exporting Countries, argued this week that oil could reach $200 a barrel largely because the market was being driven by the dollar’s slide. Movements in the euro/dollar exchange rate and the price of oil have become extremely close (see chart). An analysis by Jens Nordvig and Jeffrey Currie of Goldman Sachs shows that the correlation between weekly changes in the oil price and the euro/dollar exchange rate has risen from 1% between 1999 and 2004 to 52% in the past six months.

That link is partly a matter of accounting. If the dollar falls, the dollar price of a commodity must rise for its overall price—in terms of a basket of global currencies—to remain stable. But commodity prices have risen even when priced in non-dollar currencies. And the correlation between changes in the price of oil and the euro/dollar exchange rate has risen even when oil is priced in a basket of currencies, such as the IMF’s special drawing rights.

So is the weaker dollar driving oil prices up or are high oil prices driving the dollar down? The Goldman analysts argue the latter because oil exporters import more from Europe than America and hold less of their oil revenues in dollars. A second factor lies with central banks. Because the Fed focuses on “core” inflation (which excludes food and fuel), whereas the ECB targets overall inflation, America’s central bank runs a looser policy in response to higher oil prices, thus pushing the dollar down.

Another reason to suspect that the Fed is more than a bit player is that American interest-rate decisions have a disproportionate effect on global monetary conditions. Some emerging economies still peg their currencies to the dollar; many others have been reluctant to let their exchange rates rise enough to make up for the dollar’s decline. As a result, monetary conditions in many emerging markets remain too loose. This fuels domestic demand, pushing up pressure on prices, particularly of commodities. All of which suggests that the Fed’s decisions are propagated widely through the dollar.

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