Guillermo Calvo argues that fundamentals, not speculation, explain rising commodity prices. He says "when analysed from the perspective of some future time, this whole episode will look very much like a bubble in the commodity market, a market mirage, even though what is behind it is a fundamental factor: lower demand for liquid assets by sovereigns like China, Chile or Dubai."
Why have sovereign wealth funds lowered their demand for liquid assets? He argues that lax Fed policy is a big part of the inducement to switch out of liquid assets, and that the commodity price explosion is "a harbinger of higher CPI inflation" in the future. However, all is not lost in the inflation battle, but the Fed needs to "seriously start worrying about inflation and stop chasing imaginary destabilising speculators":
Exploding commodity prices, lax monetary policy, and sovereign wealth funds, by Guillermo Calvo, Vox EU: Oil, metals, and now food prices are heading to the sky with a virulence that is hard to rationalise on the basis of world output growth – not even on the basis of China’s and India’s fast growth, let alone the expected global slowdown. This phenomenon has been accompanied by much higher transaction volumes in forward markets. Thus, analysts and policymakers have been quick in pointing an accusing finger at the proverbial speculator, who has even been declared persona non grata in some countries, like India, where commodity futures have been banned.
The thrust of this column is that we are not going through another self-fulfilling bubble. Today’s explosion of commodity prices is the result of a very real global financial storm associated with large excess liquidity in several non-G7 countries and nourished by low G7 central banks’ interest rates. This price explosion could be a leading indicator of future inflation driven by fundamentals.
Absence of a substantial increase in physical commodity inventories has been mentioned as evidence of absence of speculative activity (by Martin Wolf and, more guardedly, Paul Krugman). But that is not valid. Suppose, for the sake of the argument, that the demand for commodities for current consumption or production is completely inelastic (food and oil are good examples in the short run). If speculators attempt to stockpile commodities, commodity prices will go up. And they will go up as much as necessary to discourage the speculators from adding to their stocks, that’s all. To keep matters simple, I will zero in on that special case and explain what drives speculators to stockpile so aggressively as to provoke a price explosion.
Incentives to stockpile commodities stem from the combination of low central bank interest rates (especially in the US) and the growth in sovereign wealth funds. The latter, in my view, is the crucial factor. Sovereign wealth funds have been created partly with the intent of switching the composition of government wealth from highly liquid but low-return assets to more risky but much more profitable investment projects. Thus, their attempt to get rid of excess liquidity resembles the econ 101 exercise in which the student is asked to trace the effects of a portfolio switch away from money and into capital. The answer is – of course – higher prices. I will return to that in a moment after I explain why central bank interest rates are also important.
Interest rates and prices
Take the Fed rate (i.e., the Federal Funds rate). Recently, the Fed rate has been sharply lowered and the market does not expect that it will be raised with equal impetus in at least one year hence. This must certainly add to sovereign wealth funds’ determination to switch away from US Treasury Bills, which, incidentally, helps to explain the suddenness of the price rise. However, Treasury Bills do not exactly fit the characteristics of the econ 101 money. If the demand for Treasury Bills goes down, their price will fall until Treasury Bills’ holders find the yield attractive enough to drop their other investment projects. In this case there would be no upward pressure on the general price level, but the effective Fed rate will likely rise. This, in turn, will induce the Fed to pump in more liquidity through open market operations, creating econ 101 money (actually, high-powered money) through the purchase of Treasury Bills. Therefore, low and momentarily pegged central bank interest rates imply that the fall in the demand for Treasury Bills results in an expansion of the money supply. Now we can confidently employ the econ 101 result to argue that the portfolio switch implies higher prices. Notice that this argument does not rely on the more standard concern that the Fed is pumping in liquidity to rescue the financial system. This may be a problem in the future but, to the extent that the Fed is simply substituting safe assets for risky assets in banks’ portfolios, the policy need not result in a sharp increase in monetary aggregates and prices.
Not all prices show the same degree of flexibility. Commodity prices are at the high end of the flexibility spectrum, while wages are likely to be on the other. Thus, the price rise phenomenon will bring about a change in relative prices in favour of commodities. Interestingly, however, eventually, as the slow-moving prices catch up, these sharp differences across prices will disappear and a much more uniform price rise phenomenon will materialise. Thus, when analysed from the perspective of some future time, this whole episode will look very much like a bubble in the commodity market, a market mirage, even though what is behind it is a fundamental factor: lower demand for liquid assets by sovereigns like China, Chile or Dubai. Overshooting of commodity prices could be large because even though sovereign wealth funds are not large in terms of wealth, they are quite large with respect to monetary aggregates. For example, several reports estimate that sovereign wealth funds’ assets under management exceed US$3.5 trillion and are growing fast, while US M1 and M2 are, respectively, US$1.4 and US$7.8 trillion as of April 2008.
Inflation to come
However, US monetary aggregates do not yet show an increase as sharp as that of commodity prices. Should we conclude that the above argument has feet of clay? There are at least two different answers to this potential objection. One answer is that under well-developed financial markets the expectation that a portfolio switch with the above characteristics will take place could trigger anticipatory price increases. The second answer hinges on the observation that Treasury Bills are possibly closer to money than to pure bonds (especially under high counter-party risk). The relevant money concept could be an aggregate involving M2 and Treasury Bills, for example. Thus, the portfolio shift, unaccompanied by a change in the Fed rate, would be tantamount to an increase in money velocity of circulation – another econ 101 experiment with similar inflationary implications. In this case, M2 need not change!
In short, my conjecture is that commodity prices are the result of portfolio shift against liquid assets by sovereign investors, sovereign wealth funds, partly triggered by lax monetary policy, especially in the US. Is this a harbinger of higher CPI inflation? If interest rates continue to be low, my answer would be a resounding yes. But there is probably room for an effective anti-inflationary battle. This will likely call for a sharp rise in interest rates and will enhance the risk of deepening recession, particularly if financial vulnerabilities have not been resolved. Thus, policymakers should seriously start worrying about inflation and stop chasing imaginary destabilising speculators.
1 See Paul Krugman “The Oil Non-Bubble,” The New York Times, May 12, 2008; and Martin Wolf, “The market sets high oil prices to tell us what to do,” Financial Times, May 13, 2008.
2 See JP Morgan Research, Sovereign Wealth Funds: A Bottom-up Primer, JP Morgan, May 22, 2008.
3 However, US M2 has accelerated quite markedly in the first quarter of 2008. In the period from January to April 2008 seasonally adjusted M2 grew at an annual rate of 10.7%, while in the period from April 2007 to April 2008 the annual rate was 6.5%. See www.federalreserve.gov/releases/h6/.
4 There are several papers in the recent literature emphasising liquidity service provided by government bonds. See, for instance, Guillermo Calvo and Carlos Vegh “Fighting Inflation with High Interest Rates: The Small-Open-Economy under Flexible Prices,” Journal of Money, Credit, and Banking, 27 (1995): 49-66; and Ravi Bansal, and John W. Coleman “A Monetary Explanation of the Equity Premium, Term Premium and Risk Free Rate Puzzles,” Journal of Political Economy, 104 (1996): 1135–1171.
5 Suppose that commodities are a subset of the goods which are transacted by means of M2. Suppose, in addition, that M2 is needed in advance to buy commodities and cpi-type goods. Thus, if cpi-type prices are sluggish and have a large weight, a modest increase in M2 would result in a large spike in commodity prices. This is another possible explanation of why inflation of commodity prices has been much larger than the rate of expansion of M2.
6 The next obvious question is: why did sovereigns (mostly in emerging market economies) engage in excessive accumulation of international reserves? My conjecture is that it was a defensive strategy (not, “neo-mercantilism,” as usually labeled) against the US beggar-thy-neighbour policy of staving off recession through lax monetary policy. I will elaborate on that in a future column.
Update: David Wessel says central banks are doing what Calvo is calling for and turning their focus to inflation:
Inflation Now Enemy No. 1, by David Wessel, WSJ: With hardly a pause for reflection, central bankers, markets and economic commentators are casting aside angst that the housing bust and credit crunch might cause another Great Depression and are turning instead to inflation anxiety. ...
Ben Bernanke, a student of economic history, knows that today's conditions are a long way from the Great Inflation of the 1970s. ... But he also knows that the Great Inflation occurred because the Fed badly misunderstood what was happening in the economy and kept interest rates too low and because consumers and businesses expected inflation and acted accordingly.
He wants to avoid the second -- the dreaded increase in "inflation expectations" -- by loudly assuring everyone that the Bernanke Fed knows its history. For much of the past year, Mr. Bernanke has demonstrated that he is determined to avoid a repeat of the Fed mistakes of the 1920s and 1930s that contributed to the Great Depression. He still is. But he also is mindful of the Fed mistakes of the 1970s that contributed to the Great Inflation, and wants you to know that he is determined to avoid those as well.