A day back I was going through the blog of Greg Mankiw, an economics professor at Harvard University. His yesterday's post talks about two articles he read giving him two hypothesis:
- Jeff Frankel : High prices of commodities like oil are being driven by low real interest rates.
- Anil Kashyap and Hyun Song Shin : With oil prices so high, Middle Eastern sovereign wealth funds should come to the rescue of Wall Street. (although I wont call it as a rescue but exploiting an opportunity)
What he derives out of these two hypothesis is a a new piece of the monetary transmission mechanism: The Fed's monetary expansion reduces interest rates >> low interest rates drive up commodity prices >> high commodity prices make OPEC rich >> and finally OPEC uses its new wealth to recapitalize our struggling financial institutions.
Jeffery Frankel, a former member of the White House council of economic advisers, points out at a flawed growth explanation. It has been said since 2003 that the growth of Asian countries and new economies have been deriving the resources consumption. As these countries were running full engines to grow at enormous rate so, the resource consumption was too high. More money after fewer resources -> prices rose higher. Now he observes that in its most recent forecast, the IMF World Economic Outlook revised downward the growth rate for virtually every region, including China. The overall global growth rate for 2008 has been marked down by 1.1 percent (from 5.2 percent in July 2007, just before the subprime mortgage crisis hit, to 4.1 percent as of January 29, 2008). And prospects continue to deteriorate. Yet commodity prices have found their second wind over precisely this period. Up some 25 percent or more since August 2007, by a number of indices. So that rebuffs the given justification.
So he comes to a conclusion: real interest rates are an important determinant of real commodity prices. He puts it like this, the 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 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.
But the events since August 2007 provide a further data point, he observes. As economic growth has slowed sharply, both in the United States and globally, the Fed has reduced interest rates, both nominal and real. Firms and investors have responded by shifting into commodities, not out. This is why commodity prices have resumed their upward march over the last six months, rather than reversing it.
That all brings me to a question, where is the problem exactly? As I see it, the problem entirely lies with the domestic consumers of US. Problem is that this consumption is so high that US consumer is also the world's largest consumer in entirety. So if they decrease consumption, every big nation feels the burnt on fiscal revenue. Also due to the transaction base being dollar, even monetary health suffers for all nations (even though their own currency gets strengthened!). Fed rate cuts brings the liquiidity in the system, which already is facing the inflation. Now how to make sure that the excess money is going in paying off debt rather than higher consumption level? or should it actually go to consumption to make world stable? Shouldn't the FD interest rates be increased to suck off the excess of 'luxury' money?
Jeffery Frankel, a former member of the White House council of economic advisers, points out at a flawed growth explanation. It has been said since 2003 that the growth of Asian countries and new economies have been deriving the resources consumption. As these countries were running full engines to grow at enormous rate so, the resource consumption was too high. More money after fewer resources -> prices rose higher. Now he observes that in its most recent forecast, the IMF World Economic Outlook revised downward the growth rate for virtually every region, including China. The overall global growth rate for 2008 has been marked down by 1.1 percent (from 5.2 percent in July 2007, just before the subprime mortgage crisis hit, to 4.1 percent as of January 29, 2008). And prospects continue to deteriorate. Yet commodity prices have found their second wind over precisely this period. Up some 25 percent or more since August 2007, by a number of indices. So that rebuffs the given justification.
So he comes to a conclusion: real interest rates are an important determinant of real commodity prices. He puts it like this, the 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 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.
But the events since August 2007 provide a further data point, he observes. As economic growth has slowed sharply, both in the United States and globally, the Fed has reduced interest rates, both nominal and real. Firms and investors have responded by shifting into commodities, not out. This is why commodity prices have resumed their upward march over the last six months, rather than reversing it.
That all brings me to a question, where is the problem exactly? As I see it, the problem entirely lies with the domestic consumers of US. Problem is that this consumption is so high that US consumer is also the world's largest consumer in entirety. So if they decrease consumption, every big nation feels the burnt on fiscal revenue. Also due to the transaction base being dollar, even monetary health suffers for all nations (even though their own currency gets strengthened!). Fed rate cuts brings the liquiidity in the system, which already is facing the inflation. Now how to make sure that the excess money is going in paying off debt rather than higher consumption level? or should it actually go to consumption to make world stable? Shouldn't the FD interest rates be increased to suck off the excess of 'luxury' money?
Labels: Economics
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