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.

Making money work.

No this is not a pitch for a Suze Orman therapy session, you have to watch Oprah for that. But a recent comment got me thinking back to an idea that I had read some time ago--an idea about getting money moving again in a way that is much simpler and potentially less costly than anything we have undertaken thus far.

During economic downturns, the Federal Reserve typically uses monetary policy (generally, lowering interest rates) in order to help spur economic growth. The problem is that we are in a period of extremely low (or even practically zero) interest rates. Given that, it might seem that the Federal Reserve is sort of like a baseball team with no bullpen. Once the starters are out of gas, what do they do, just give up? Not exactly some economists would argue. Particularly economist Scott Sumner on his blog TheMoneyIllusion.

Banks, being regulated institutions, are required to hold a certain amount of their deposits as reserves. The Fed then pays interest on those reserves. High interest rates on reserves give a bank an incentive to keep reserves high, even above the amount required by regulation. Low interest rates on reserves discourage holding reserves beyond the required amount.

Therefore, since many people seem to agree that it should be the policy of the government at this time to encourage banks to lend and to discourage them from simply holding on to cash, what should be the policy of the government towards reserves? Here is economist Sumner:

One easy step would be to stop paying interest on reserves. These interest payments increase the demand for reserves, and are thus deflationary...then why not go one step further and charge an interest penalty on excess reserves?

No complicated scheme for purchasing assets that nobody knows how to value. I mean, most of the TARP money is spent and I have yet to see the green glow of a toxic asset emanating from Tim Geithner's desk. No capital injection along with a personalized note from Rep. Barney Frank asking if the nation's major financial institutions could start lending money again, pretty please.

It's a straight forward proposal. No pleading, no appealing to the better angels. No carrots. All stick. The Fed simply tells banks we don't care whether or not you sit on your money, but we are not going to pay you to do so. In fact, we are going to start charging you for making us watch this big pile of money just sit there. You don't want to lend it, fine. But why should we store it for free, at least under current conditions.

Sumner concedes this amounts to 'unconventional' monetary policy, but hey, these are unconventional times. He also notes, with (barely) disguised glee, that others may be coming around to this suggestion.

Monetary policy & where the rubber meets the road

At this link you can check out a primer on Quantitative Easing. Quanti-what, you might ask. This is one of the more unusual tools that a central bank like the Fed can use when interest rates are already very low. Don't wory, the primer is a video with talking and graphics, no reading required. Just sit back and enjoy.

I wouldn't say that using QE means were in 'duck and cover' mode, but we certainly have crossed over into 'spare tire' territory.

Let's just hope it is a full size spare and not one of those bizarre miniature spare tires that seem to be the norm. It's bad enough when you are on the side of the road changing a flat that cars pass by at such incredible rates of speed you feel like you are part of a nascar pit crew, only you are wearing a tie and shoes that hurt your feet; but then when you get back in your car and on the road again, everyone can still tell you just had a flat because of the dinky spare that is causing your car to pull dangerously to one side. I mean, sure, you can white-knuckle it for a few miles, but at some point you consider lashing your hands to the wheel like some 19th century sailor at the helm of a ship headed straight into the gaping jaws of a storm at sea.

Anyway, those little spare tires are the automotive equivalent of a scarlett letter.

As an added bonus the QE video narrator has an English accent. I personally believe everything sounds better with an English accent. That is why I feel strongly that all announcements about the future national debt should be made by the actor Michael Caine, or if he is not available, the Geico lizard.
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h/t on the QE primer to Mankiw. All the rambling about spare tires and English accents is mine.

The Fed's Fortune Cookie: Your Influence Will Wane...But A New Love Is On The Horizon

The Federal Reserve's Open Market Committee began their regularly scheduled meeting today, but it appears that at least some commentators believe they needn't have bothered. Specifically, Sebastian Mallaby of the Washington Post.

In this column from Sunday, Mallaby takes up the case of China and its currency manipulation. No doubt many of you read "China" and "currency policy" and immediately begin to fade. Hang in there, he makes it worth your while. Only two sentences into his second paragraph he drops this little nugget:

What's more, this manipulation is arguably the most important cause of the financial crisis. Starting around the middle of this decade, China's cheap currency led it to run a massive trade surplus. The earnings from that surplus poured into the United States. The result was the mortgage bubble.

There you have it. The next time someone asks what caused the housing bubble and its aftermath the simple answer is cheap money from China. This in itself is really not that surprising since the cheap-Chinese-money-theory has been one of the handful of standard explanations that has been making the rounds ever since "pin the cause on the crisis" became America's number one parlor game (or at least it would be if anyone had parlors anymore). A few paragraphs on, Mr. Mallaby breezily dismisses two of the competing theories for the current mess as if they were almost beneath consideration.

This, then, brings us back to the Fed. Mr. Mallaby continues:

Could the Fed have raised interest rates to avert the bubble? The Fed's monetary policy was indeed too loose. But as Martin Wolf argues in his recent book, "Fixing Global Finance," it's not clear that higher interest rates could have prevented the trouble. Once China decides to export vast quantities of capital, that capital has to go somewhere. Higher interest rates in the United States might have encouraged the world's savers to park even more of their capital in this country.

According to this analysis if China decides to return cash to the United States in the form of investment, there is little the Fed can do to prevent an inflationary bubble. The best it can do is to try and limit the magnitude of the bubble by mounting a fighting retreat against any other influxes of capital.

The staggering implication of this is that in large part the US has surrendered control of its monetary policy to the Chinese government. If you think the Ron Paul crowd are perturbed by the Fed's inflationary policies, I have to believe a realization that we mortgaged our future to the Chinese for some cheap televisions and tennis shoes would be enough to drive them to apoplexy.

The unsettling thing about Mr. Mallaby's analysis is not his shocking description of the Fed's impotence, but the fact that he is really not that concerned by it. His article does not call for Americans to stop surrendering their economic self-determination or make an attempt to shame China for its hand in the crisis. As a committed globalist who probably looks on things like nation-states and international borders as quaint relics of the past, Mr. Mallaby is more concerned that China learn from this crisis what the oil shocks taught OPEC. The lesson for China is not to stop trying to manipulate the U.S. market, but to do so in a way that is their own economic interest. Basically, don't kill the goose that lays the golden eggs.

No doubt those that have lost jobs due to overseas competition know all to well the costs of trade. It is time that all Americans realize that there are many sorts of costs associated with trade and currency policies, both ours and those of our trading partners.