Lecture I: Monetary Influences on Commodity Prices

1. Monetary Policy & Commodity PricesStudy Center Gerzensee23-25 June, 2014Jeffrey FrankelHarpel Professor, Harvard University Lecture I: Monetary Influences on Commodity Prices

2. Commodity prices have been volatile in recent years. • What causes swings such as the 2008 & 2011 price spikes? • The role of real interest rates. • Appendices: • I. Do speculators destabilize prices? • II. Long-term commodity price trends.

3. Oil prices, for example, spiked in 2008,and reached a 2nd peak in 2011.

4. The impact on commodity-exporting developing countries • Developing countries tend to be smaller than major industrialized countries, and more likely to specialize in the exports of basic commodities like oil, minerals, & agricultural commodities. • So they are more likely to fit the small open economy model: • price-takers, • not just for their import goods, • but for their export goods as well. • That is, the prices of their tradable goods are taken as given on world markets.

5. The determination of the export price on world markets • The price-taking assumption requires 3 conditions: • low monopoly power, • low trade barriers, • Homogeneity: intrinsic perfect substitutability as between domestic & foreign producers – • a condition usually met by primary products • and usually not met by manufactured goods & services. • Besides homogeneity, we will also be assuming storability. • To be precise, not all barrels of oil are the same,nor are traded in competitive markets. • But the assumption that most commodityproducers are price-takers holds relatively well.

6. A qualification: Monopoly power • Saudi Arabia does not satisfy the 1stcondition, due to its large size in world oil markets. • If OPEC functioned effectively as a true cartel, then it would possess even more monopoly power in the aggregate.

7. The determination of the export price continued • To a 1st approximation, then, the local commodity price = (the exchange rate) X ($ price on world markets). (sj/c) = (s j/$) + (s$/c) where s j/$ ≡ spot exchange rate in units of currency j per $, s $/c ≡ spot price of commodity c in terms of $; • => a devaluation should push up the commodity price quickly and in proportion • leaving aside pre-existing contracts • or export restrictions.

8. Why are commodity prices so volatile? • Demand elasticities are low in the short run, because the capital stock is designed to operate with a particular ratio of material inputs to output. • Supply elasticities are also often low in the short run, because it takes time to adjust output. • Because priceelasticitiesof supply&demand are low, relatively small fluctuations in demand or supply (due, e.g., to weather) require a large change in price to re-equilibrate supply & demand.

9. high elasticities low elasticities A given rise in demand causesa small price rise or a big price risewith with D D' S Poil Poil The increase in demand drives up the price D D' { S { Supply & demand for commodity Supply & demand for commodity

10. Volatility, continued • Inventories can cushion the short run impact of fluctuations, • but they are limited by storage costs • due to capacity constraints and • carrying cost (interest rate, insurance, spoilage…)

11. Volatility, continued • In the longer run, elasticities are far higher, bothon thedemand sideand thesupply side. • This dynamic was clearly at work in the oil price shocks of the 1970s – • quadrupling after the 1973 Arab oil embargo • doubling after the Iranian revolution of 1979, • which elicited relatively little consumer conservation or new supply sources in the short run, but a lot of both after a few years had passed.

12. Volatility, continued In the medium run, • people started insulating their houses and driving more fuel-efficient cars, • and oil deposits were discovered & developed in new countries. • This is a major reason why the real price of oil came back down in the 1980s-1990s.

13. Price of oil, 1970-2007

14. Volatility,continued In the medium term, commodities can showa cob-web cycle, due to the lags in response: • The initial market equilibrium is a high price; • the high price brings forth investment • and raises supply after some years, • which in turn leads to a new low price, • which discourages investment, • and thus reduces supply with a lag • and so on. • In theory, if people have rational expectations, they should look ahead to the next price cycle before making long-term investments in housing or drilling. • But the complete sequence of boom-bust-boom over the last 35 years looks suspiciously like a cobweb cycle nonetheless. 2 1 3 4

15. Four explanations for big recent increases in the prices of oil, minerals & agricultural commodities • (1) global growth • especially China • (2) speculation • defined as purchases of commodities, in anticipation of gain at the time of resale. • However, this includes: • not only possible destabilizing speculation (bandwagons), • but also stabilizing speculation. • (3) easy monetary policy • reflected in low realinterestrates. • (4) financialization: • open position in commodities futures, • by commodity index funds & other traders • esp. since 2005

16. Monetary influences on commodity prices • We will show an arbitrage condition between the physical stock of a storable commodity like oil and the interest rate. • The real price of oil should be high during periods when real interest rates are low (e.g., due to easy monetary policy), • so that a poor expected future return to holding oil offsets the low interest rate. • By contrast, when real interest rates are high (e.g., due to tight money), current oil prices should lie below their long-run equilibrium, • because an expected future rate of price increase is needed in order to offset the high interest rate.

17. High real interest rates reduce the price of storable commodities through 4 channels: • ¤ by increasing the incentive for extraction today • rather than tomorrow • think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled. • ¤ by decreasing firms' desire to carry inventories • think of oil inventories held in tanks. • ¤ by encouraging speculators to shift out of commodity contracts, and into treasury bills • the “financialization" of commodities. • ¤ by appreciating the domestic currency • and so reducing the price of internationally traded commodities in domestic terms even if the price hasn't fallen in terms of foreign currency.

18. The mechanisms at work in recent history • Very low US real interest rates boosted commodity prices toward the end of the 1970s, • especially in $ terms; • high US interest rates drove them down in the 1980s, • especially in $. • In recent years, e.g., 2008, low interest rates again contributed to high commodity prices. • References by the author include Frankel, 1986, 2005, 2008a,b, 2014; Frankel & Hardouvelis, 1985; Frankel & Rose, 2009. • Also Barsky & Summers, 1988; and Caballero, Farhi & Gourinchas, 2008. • Barsky & Killian, 2002, and Killian, 2009: many big oil price “shocks” have in reality been endogenous with respect to monetary policy.

19. Figure 1a: Real commodity price index (Moody’s) and real interest rates

20. Figure 1b: Real commodity price index (Moody’s) and real interest rates

21. The overshooting theory mechanics • Monetary contraction temporarily raises the real interest rate • whether via rise in nominal interest rate, fall in expected inflation, or both. • Inventory demand falls (<= high “cost of carry”). • => Oil prices fall. • How far? • Until oil is widely considered "undervalued" • -- so undervalued that there is an expectation of future appreciation, • together with other advantage of holding inventories: the "convenience yield,” • that it is sufficient to offset the higher interest rate • and other costs of carrying inventories: esp. storage costs. • Only then are firms willing to hold the inventories despite the high carrying cost. • In the long run, the real interest rate & real commodity price return to equilibrium values.

22. Literature on inventories • We need to include inventories, • E.g., Working(1949); Deaton&Laroque(1996); Ye, Zyren& Shore(2002,05,06) • and the role of speculation & interest rates. • Some have found evidence in inventory data for an important role for speculation, • driven by geopolitical fears: • disruption to the supply of Mideastern oil. • Kilian & Murphy (2013); Kilian& Lee (2013). • But the speculative factor is inferred implicitly • rather than measured explicitly.

23. Empirical innovations of the 2014 paper • Relative to past attempts to capture the roles of speculation or interest rates via inventories: • How to measure speculation, i.e., market expectations of future commodity price changes? • Survey data collected by ConsensusForecasts • from “over 30 of the world's most prominent commodity forecasters.” • How to measure perceived risk to commodity availability? • Volatility implicit in options prices.

24. Derivation & estimation of the model • 1) The overshooting model • shows the effect of the real interest rate on the real commodity price, • holding storage costs constant. • We can also show how the local-currency commodity price depends on the local interest rate too. • 2) We can infer storage costs from inventories. • 3) The full commodity price equation • Adds to the overshooting model: • inventories / storage costs; • & economic activity / convenience yield.

25. 1st assumption: regressive expectations E [Δq] = - θ (q-) (1) E [Δ (s – p ) ] = - θ (q-)(2)where • q ≡ s-p, the (log) real price of the commodity, • ≡ long run (log) equilibrium real commodity price, • s ≡ natural logarithm of the spot price, and • p ≡ (log of) economy-wide price index.

26. E (Δs) = - θ (q-) + E(Δp). (2)+ 2nd assumption: speculative arbitrageE(Δs) + C = i, (3)where: C ≡ cy – sc – rp. =>- θ (q-) + E(Δp) + C = i=>q - = - (1/θ) [i - E(Δp) – C ] (4) . • q is inversely proportionate to the real interest rate, • ifand C are constant.

27. The overshooting model : q is inversely proportionate to the real interest rate Regression of real commodity price indices against real interest rate (1950-2012)

28. For a model of commodity prices in local currencies,combine commodity price overshootingwith Dornbusch exchange rate overshooting. (sj/cj/c)) = (s j/$- j/$)+(s$/c- $/c) = (pj-j)- (1/ν)(ij- i$ - [Ej –E $]) - (1/θ)(i$–E$ – C) (qj/c - j/c)= - (1/ν) (rj-r$ ) - (1/θ) (r$ –C). (9) where s j/$ ≡ spot exchange rate in units of currency j per $, s $/c ≡ spot price of commodity c in terms of $; pj & p$≡ the price levels; j & $ the inflation rates; q j/c ≡ real price of commodity c in terms of currency j ;r$& rj≡ the real interest rates in the US & country j .

29. The overshooting equation for commodity prices in local currencies • Equation (9) says the real commodity price observed in country j is high to the extent that • either the US real interest rate is low, • or the local real interest rate is low • relativeto the US real rate. • Equation tests for 8 floating-currency countries: • Local & US real interest rates do have significant effects on local real commodity price indices (CRB, Dow Jones, The Economist, Goldman Sachs, Moody’s & Reuters). • Frankel(2008).

30. Regressions of commodity price in local currency on interest rates Monthly observations(over largest possible sample of data since 1950) *significance at 5% significance level.Robust standard errors are reported.

31. Derivation of inventory demand equation E (Δs) + cy – sc – rp = i (3) or sc = [E (Δs)-i] +cy – rp. (7) 3rd assumption: Storage costs rise with the extent to which inventory holdings strain existing storage capacity: sc = Φ (INVENTORIES). Invert: INVENTORIES = Φ-1 { sc } . And combine with the arbitrage condition (7): INVENTORIES = Φ-1{[E(Δs)-i] +cy – rp}(8) The carry trade model

32. Table 4 -- Oil Inventory Equation(1995-2011) 58 observations,quarterly

33. Now put inventories into the commoditypriceequationWhen inventories rise, the commodity price falls. WEO, IMF, April 2012

34. Complete equation for determination of price There is no reason for the net convenience yield, C, to be constant. C ≡ cy – sc – rp(3)q- = - (1/θ) (i - E(Δp) – C)(4) Substituting from (3) into (4), q = - (1/θ) [i-E(Δp)]+ (1/θ) cy - (1/θ) sc - (1/θ) rp(5) Hypothesized effects: • Real interest rate: negative • Convenience yield: positive • Economic activity • Risk of disruption • Storage costs: negative • sc = Φ (INVENTORIES). • Risk premium • Measured directly:[E(Δs)-(f-s)] • Or as determined by volatility σ: ambiguous • Measured by actual volatility or option-implied subjective volatility

35. Estimation of determination for real prices,commodity-by-commodity, 1950-2012 *** p<0.01, ** p<0.05, * p<0.1 (Robust standard errors in parentheses.) † Some commodities have shorter sample periods.

36. Estimation of determination for real prices,commodity-by-commodity, 1950-2012, continued *** p<0.01, ** p<0.05, * p<0.1 (Robust standard errors in parentheses.) † Some commodities have shorter sample periods.

37. A panel across all 11 commoditiesoffers hope for greater statistical power

38. Panel across all 11 commodities; First differences guard against non-stationarity

39. In conclusion… • The model can accommodate each of the explanations for recent increases in commodity prices: economic activity, speculation, and easy monetary policy. • Based on “carry trade”: arbitrage relationship between expected price change & costs of carry: interest rate, storage costs & convenience yield. • And on “overshooting”: prices are expected to regress gradually back to long-run equilibrium

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41. Appendix I:Do speculatorsdestabilize prices? • Yes, speculators are important in commodities markets.   • The spot price is determined in markets where participants typically base their supply & demand in part on their expectations of future increases or decreases in the price.    • That is speculation.  • But it need not imply bubbles or destabilizing behavior.

42. Are speculators bad?continued • Speculators often fulfill useful functions: • If they know the price is temporarily high, they sell short, thereby moderating today’s high price. • If they have reason to think there will be a future increase in demand, they go long, thereby driving up today’s low price and sending the market signal needed to spur investment. • In these cases they are the messenger delivering the news about economics fundamentals. • Admittedly, there are sometimes speculative bubbles, a self-confirming movement of the market price away from fundamentals.

43. An example of commodity speculation In the 1955 movie version of East of Eden, the legendary James Dean plays Cal. Like Cain in Genesis, he competes with his brother for the love of his father.  Cal “goes long” in the market for beans, in anticipation of a rise in demand if the US enters WWI.

44. An example of commodity speculation, cont. Sure enough, the price of beans goes sky high, Cal makes a bundle, and offers it to his father, a moralizing patriarch.  But the father is morally offended by Cal’s speculation, not wanting to profit from others’ misfortunes, and tells him he will have to “givethemoneyback.” 

45. An example of commodity speculation, cont. • Cal has been the agent of AdamSmith’s famous invisiblehand: • By betting on his hunch about the future, he has contributed to upward pressure on the price of beans in the present, • thereby increasing the supply so that more is available precisely when needed (by the Army).  • The movie even treats us to a scene where Cal watches the beans grow in a farmer’s field, something real-life speculators seldom get to see.

46. Appendix II:Long-term world price trend • (i) The old “structuralist school” (Prebisch-Singer): • The hypothesis of a declining commodity price trend • (ii) Hypotheses of a rising price trend • Hotelling, non-renewable resources, & the interest rate • Malthusianism & the “peak oil” hypothesis • (iv) Empirical evidence • Statistical time series studies

47. Permanent upward trend?It looked like it in 2007. Price of oil

48. But not in 2009.One needs to look at the very long term

49. (i) The old “structuralist school”Raul Prebisch(1950) & Hans Singer (1950) • The hypothesis: a declining long run trend inprices of mineral & agricultural products • relative to the prices of manufactured goods. • The theoretical reasoning: world demand for primary products is inelastic with respect to world income. • That is, for every 1 % increase in income, raw materials demand rises by less than 1%. • Engel’s Law, an (older) proposition: households spend a lower fraction of their income on basic necessities as they get richer. • Demand => P oil

50. Structuralists, continued • This hypothesis, if true, would imply that specializing in natural resources was a bad deal. • Mere “hewers of wood & drawers of water” would remain forever poor if they did not industrialize. • The policy implication of Prebisch: • developing countries should discourage international trade with tariffs, • to allow their domestic manufacturing sector to develop behind protective walls, • rather than exploiting their traditional comparative advantage in natural resources • as the classic theories of free trade would have it.