THE STASH OCTOBER 15, 2009
I've highlighted a couple recent papers investigating the causes of the commodity price boom, pre-crisis. This one chalks it up as a perfectly expectable response to rising demand, while this one says that though there's little evidence of manipulation, the financialization of commodities did allow the market to develop a bubble.
Now here comes a third paper from a group of Fed economists examining another possible cause for the oil price boom -- the interplay between Federal Reserve decisions, the dollar, and countries who try to align their monetary policies with the U.S.:
This explanation, which for convenience we will call the "dollar bloc" story, starts with the premise that many developing economies have pegged their currencies to the U.S. dollar. Accordingly, when the Federal Reserve loosened monetary policies, starting in the fall of 2007, these developing countries had to loosen their policies as well, even though such loosening was not appropriate to their economic circumstances. This led to an overheating of their economies, excess demand for commodities, and sharp increases in commodity prices.
But the researchers, Christopher Erceg, Luca Guerrieri, and Steven Kamin, find this explanation lacking. First, the following chart shows how interest rates in dollar-linked countries didn't, as conventional wisdom presumes, follow the U.S.'s downward:
Second, using a fancy economic model created by the Fed staff, the researchers find that even if many developing countries followed the Fed in setting interest rates, oil prices would not rise anywhere near as high or stay at the elevated levels that we experienced:
The effect is short-lived both because loose monetary policy can keep output above its equilibrium level for only a limited period of time, and also because the runup in oil prices induces demand adjustments that subsequently allow prices to come down.
Finally, the researchers find that a combination of increased growth and declining oil output can account for all of the rise in oil prices:
We performed a number of simulations to assess the plausibility of the most prominent "fundamentals" based explanations for the surge in oil prices. To begin with, we analyzed the effects of an acceleration of productivity growth sufficient to boost world GDP growth by about 1 percentage point; this increase is comparable to the runup in global growth seen earlier this decade compared with its historical average. Our model simulation suggests that such an increase in economic growth, because it is sustained, could lead to a similarly sustained rise in oil prices in the neighborhood of 70 percent above their baseline level.
We then evaluated the impact of a sustained reduction in the growth of global oil production of 1 1/2 percentage points, comparable to the reduction in growth that actually occurred in recent years. Such a shock would boost the price of oil persistently more than 30 percent above its baseline level. Combining both simulation experiments, we find that the higher global GDP growth and the reduction in oil supply would together lead to a sustained doubling of the oil price, comparable to where oil prices now stand relative to their value earlier this decade.
Low interest rates during the early 2000's have been -- wrongly in my view -- blamed for causing the housing crisis, and it looks like they probably don't explain the commodity boom either. What's alarming about the fundamentals view, unfortunately, is that once economies move past the trough of the current cycle, there's nothing to stop commodity prices from zooming higher all over again.