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Thursday, May 29, 2008

Two from Jeff Frankel: Whether We are Currently in a Recession and the Impact of Monetary Policy on Commodity Prices

There are two different topics to choose from, so let's start with the latest news on GDP. Today, GDP growth for the first quarter was revised upward from .6% to .9%. How does this affect the odds that we are currently in a recession? Jeff Frankel is a member of the NBER's Business Cycle Dating Committee:

Despite Positive First Quarter, Odds of 2008 Recession Are Still Above 50%, by Jeff Frankel: The Commerce Department this morning revised upward its estimate of first quarter growth in real GDP to 0.9% (precisely in line with the expectations of economic forecasters).

As a member of the Business Cycle Dating Committee of the NBER, I am asked frequently if the country is entering a recession, or if we have already done so. I cannot speak for the Committee, and I am not a professional forecaster. But I can give my views, for what they are worth.

It is hard to say that we entered a recession in the first quarter, without a single negative growth quarter, let alone two of them. Even so, three minor qualifications to that 0.9% remain: 1) The number will be revised again, and could move in either direction. 2) A bit of the measured growth consisted of an increased rate of inventory investment, which was almost certainly not desired by firms and is likely to reverse in the 2nd quarter 3) As Martin Feldstein has pointed out, the QI growth number is defined as the change for the quarter as a whole relative to QIV of 2007; within QI, the information currently available suggests that GDP fell from January to February to March.

The reason why many suspected a QI turning point in the first place is employment, which is virtually as important an indicator to the NBER BCDC as is GDP. Jobs have been lost each month since January. Total hours worked is my personal favorite, because in addition to employment it captures the length of the workweek, which firms tend to cut before they lay off workers. This indicator too has been falling.

And of course there are the longer run indicators that have been very worrisome for almost a year: depressed household balance sheets, mortgage defaults, high oil prices, low consumer confidence, etc.

The economy is a four-engine airplane flying at stall speed, skimming along the top of the waves without yet going down. ... The big question mark is the consumption engine. Is the long-spending American household taking a hard look at its diminished net worth and taking steps to raise its saving rate above the very low levels of recent years?

We are already clearly in a “growth recession.” All in all, I put the odds of an outright recession sometime this year at greater than 50%. That number is meant to add together: (1) the odds that it will turn out that we have already entered reached the turning point and (2) the odds that the sharp recent expansions in monetary and fiscal policy will succeed in postponing the recession, but only until later in the year. Come the fall, if demand starts to slow, I can’t see either the Fed delivering a second big dose of interest rate cuts (as they were able to in the 2001 recession, when the dollar was strong and inflation under control), nor the government delivering a second big dose of tax cuts (as they could in the 2001 recession, when the budget outlook was strong and debt under control).

Next, a different topic. Jeff Frankel defends his argument that high commodity prices are the result of easy monetary policy:

Monetary policy and commodity prices, by Jeffrey Frankel, Vox EU: In a speech delivered last week, Federal Reserve Vice Chairman Donald L. Kohn addressed a theory to which I am partial: the theory that low real interest rates have contributed to the continued rise in prices of agricultural and mineral commodities, including oil, over the last year. He said:

“Some observers have questioned whether the news on fundamentals affecting supply and demand in commodities markets has been sufficient to justify the sharp price increases in recent months. Some of these commentators have cited the actions of the Federal Reserve in reducing interest rates as an important consideration boosting commodity prices. To be sure, commodity prices did rise as interest rates fell. However, for many commodities, inventories have fallen to all-time lows, a development that casts doubt on the premise that speculative demand boosted by low interest rates has pushed prices above levels that would be consistent with the fundamentals of supply and demand. As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies, hence raising the amount demanded by people using those currencies. But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one.”
(Speech at the National Conference on Public Employee Retirement Systems, New Orleans, Louisiana, May 20, 2008).

As real interest rates have come down over the last year, real commodity prices have accelerated upward despite declining economic growth, as shown in Figure 1, where the commodity price has been inverted so that one can see the correlation visually.

Figure 1. The real interest rate and commodity prices, January 2007 – April 2008

The effect of interest rates can be demonstrated both theoretically and empirically. I have argued that the effect can come through any of three channels: inventories, production, and financial speculation.

Historically, real interest rates have had an inverse effect on oil inventories (when controlling econometrically for three other relevant factors). Nevertheless, I have to admit that inventory levels have not over the last year risen in a way that would support the theory. I thus have to rely more on the other channels of transmission to explain recent developments.


Stocks of oil held in deposits underground dwarf those held in inventories aboveground, and the decision how much to produce is subject to the same calculations trading off interest rates against expected future appreciation that apply to inventories. (The classic reference is Hotelling’s Rule.)

Apparently the Saudis have decided to leave theirs in the ground. “King Abdullah, the country’s ruler, put it more bluntly: ‘I keep no secret from you that, when there were some new finds, I told them, ‘No, leave it in the ground, with grace from God, our children need it’.’’’ (Financial Times 19 May). I see the interest rate as part of the Saudis’ decision. Because the current rate of return on financial assets is abnormally low, they can do better by saving the oil for the future than by selling it today and investing the proceeds. Holding back production raises today’s oil price, to a point where the expected future return on oil has fallen to the same level as the interest rate. Hence the inverse effect of real interest rates on real oil prices. The same logic governs others’ decisions regarding how much copper to mine, how much forest to log, etc.

Cross-country evidence

In addition to the link from world real interest rates to world real commodity prices, there is a further link from individual countries’ real interest rates to commodity prices expressed in their own currencies. This link primarily passes through their exchange rates: A country that eases monetary policy relative to the United States will experience a depreciation of its currency, and a proportionate further increase in commodity prices expressed in its own currency. For small countries with commodity markets perfectly integrated into world markets, the link comes entirely through their exchange rate. But some mineral markets and particularly agricultural markets are not in fact perfectly integrated, so that some of the effect of local monetary policy may come through local inventory or underground channels rather than the exchange rate.

The equation governing real commodity prices in a non-dollar country is (Frankel 2006):


  • is the real price of commodities in terms of currency j
  • is the real-fundamentals price of commodities in terms of currency j
  • is the US interest rate
  • is the interest rate in country j
  • is convenience yield of holding the commodity (net of storage costs and risk premium)

Table 1 reports results on data from the last 56 years.

Table 1
Real commodity prices in local currency and real interest rates

Note: * indicates coefficient significant at the 5% level of significance. Robust standard errors are reported.

I tested the equation on eight countries, chosen to have floating exchange rates (with a preference for countries with a commodity sector. One could equally well interpret the theory as referring to short-term interest rates or long-term interest rates. I tried both. The results show a significant negative coefficient on the real US interest rate, representing global monetary policy, as well as on the real interest differential between the national economy and the United States, representing local variations in monetary stance. This is true regardless whether one looks at the results for short-term or long-term interest rates.

The commodity price index that was used in this table comes from the Commodity Research Bureau. But I also tried the test on five other prominent commodity price indices compiled by others, with similar results. In general, the evidence appears to support the hypothesis regarding the determination the real local-currency index of commodity prices.
As many observers have recently noted, the effect is equally applicable to the United States: When the Fed eases and the dollar depreciates, the price of oil in dollars goes up quickly even if it does not change in euros. In the past, many thought that there would be little effect because oil is invoiced in dollars.


Frankel, Jeffrey (2006). “The Effect of Monetary Policy on Real Commodity Prices” in John Campbell (editor) Asset Prices and Monetary Policy, University of Chicago Press.

    Posted by on Thursday, May 29, 2008 at 12:06 PM in Economics, Monetary Policy, Oil | Permalink  TrackBack (0)  Comments (19)


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