What's Driving Commodity Prices

Professor James Hamilton has been examining the increase in dollar commodity prices and their tendency to move together on his blog Econbrowser. Last week's price drop offers some additional insight into the phenomenon.

Hamilton argues that there is a more convincing explanation for commodity prices than a strengthening of the world economy or inflation fears:

A more natural interpretation of Friday's commodity price moves would be based on the role of low short-term interest rates in encouraging the commodity price boom. The sooner U.S. employment recovers, the sooner the Fed will start raising interest rates, and the sooner the game of putting borrowed cash into commodities would be up...

The Fed is accustomed to thinking of unemployment as the key predictor of inflation, and of relative commodity prices as a separate factor beyond its direct control. I read Friday's market moves as one more suggestion that commodity price inflation may have more to do with U.S. monetary policy, and less to do with U.S. employment, than many within the Fed are prepared to acknowledge.

While it's true that low interest rates do not automatically mean an expansion of money in the economy, there would seem to be something to the notion that low costs of borrowing can have in inflationary impact on assets. As people are able to borrow relatively cheaply they may be inclined to bid-up asset prices. This seems to be at least part of the story of the housing bubble.

The way that interest rates, reserve requirements, savings habits (at home and abroad), and demand for currency interact is complicated and from what I can tell is not a settled question among the academics.

If in fact we are entering an era where a common side effect of low interest rates are asset price bubbles (even minor ones) Central Banking would seem to be little more than squeezing a balloon. And as anyone with kids can tell you eventually the balloon pops, then the crying starts.