Why are commodity prices high?

The popular explanation for the spectacular rise in the prices of energy, minerals, farm products, and other industrial inputs has been rapid growth in the world economy. China booming, India getting into the high growth bus, American consumers spending away like there is no tomorrow, even the Europeans consuming aggressively - these are some of the commonly mentioned reasons.

Professor Jeffrey Frankel of the Harvard Kennedy School argues that this may not tell the whole story, since commodity prices have soared more than 25% since August 2007, despite all the major economies slowing down and expectations of a US recession mounting. His more profound macroeconomic explanation is: "real interest rates are an important determinant of real commodity prices".

He writes that "high interest rates reduce the demand for storable commodities, or increase the supply, through a variety of 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 spot commodity contracts, and into treasury bills".

"All three mechanisms work to reduce the market price of commodities, as happened when real interest rates where high in the early 1980s. A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories, and raising commodity prices, as happened in the 1970s, and again during 2001-2004. It's the original "carry trade.""

He summarizes the theoretical model,"A monetary expansion temporarily lowers the real interest rate (whether via a fall in the nominal interest rate, a rise in expected inflation, or both -- as now). Real commodity prices rise. How far? Until commodities are widely considered "overvalued" so overvalued that there is an expectation of future depreciation (together with the other costs of carrying inventories: storage costs plus any risk premium) that is sufficient to offset the lower interest rate (and other advantages of holding inventories, namely the "convenience yield"). Only then do firms feel they have high enough inventories despite the low carrying cost. In the long run, the general price level adjusts to the change in the money supply. As a result, the real money supply, real interest rate, and real commodity price eventually return to where they were. The theory is the same as Rudiger Dornbusch's famous theory of exchange rate overshooting, with the price of commodities substituted for the price of foreign exchange".

As economic growth slowed sharply since August 2007, both in the United States and globally, the Fed reduced interest rates, both nominal and real. Firms and investors responded by shifting into commodities, not out. This, Prof Frankel claims, is why commodity prices have resumed their upward march over the last six months, rather than reversing it.

Paul Krugman picks holes in this arguement, claiming that contrary to what should have been happening if this were true, commodity inventories have actually been falling.

The weak dollar may also have contributed to the rise in commodity prices. With most global commodities being priced in dollars, a weak dollar makes commodities cheap for non-US buyers. The aggressive rate cuts of the Fed, which will further weaken the dollar, will in turn drive up the prices of commodities contracts.