Oil prices have plummeted ~ 50% since mid of this year, worthy news for oil-importing nations, but evil news for exporting countries such as Russia, Venezuela, Nigeria, etc.
Some attribute the price drop to the US shale-energy boom and others cite OPEC’s failure to agree on restrictions for the supply.
But that only seems to be part of the whole story. The price of iron ore, gold, and silver are down too. And let’s not forget the same is true for sugar, cotton, and soybean prices. In fact, the truth, not glanced by many is that most of the dollar commodity prices have fallen since the first half of the year. Not forgetting that a host of sector based factors affect the price of respective commodity, the fact that the decline is so broad – as is often the case with giant price swings, only suggests that macroeconomic factors are at labor.
So, what macroeconomic factors are we talking about, that could be driving down the commodity prices? Imaginably it is deflation. Though inflation is low, and negative in a few countries, something more is probably going on, because commodity prices are falling relative to the overall price level. In other words, real commodity prices are falling.
The most common explanation that is put forward is the global economic slowdown, which has diminished demand for energy, minerals, and agri products. Indeed, growth has slowed and GDP forecasts have been revised downward in most countries.
Nevertheless, United States is a major exception in the whole gamut. American expansion seems well established, with an projected annual growth exceeding 4 percent over the last two-three quarters.
And yet it is predominantly in the US that commodity prices are falling. If we observe the Economist’s euro-denominated Commodity Price Index, it has actually risen over the last year; and it is only the Index in terms of dollars, which is what we all put attention to – that is down. That calls for an attention to the monetary policy, the significance of which as a determinant of commodity prices is often forgotten or never paid attention too.
Monetary tightening is widely anticipated in America, with the Federal Reserve having ended quantitative easing recently and likely to raise short-term interest rates sometime in the year 2015. This, if you have not yet been able to guess, recalls a historical pattern. Falling real interest rates in the 1970s, and 2000s, which were accompanied by rising of real commodity prices; and in addition, steep increase in US real interest rates in 1980s had sent dollar commodity prices sinking.
There is something instinctive about the idea that when Fed prints money, the money flows majorly into commodities, and thereon bids their prices to go up and thus in relation to that prices fall when interest rates rise. But, what, exactly, is the fundamental mechanism?
There are four canals through which the real interest rate affect the real commodity prices, obviously keeping aside from the effect it has via the level of economic activity.
First, high interest reduces the price of storable commodities by increasing the incentive for extraction today, thereby boosting the pace at which oil is pumped, gold is mined, or forests are logged.
Second, high rates also decrease firms’ desire to carry inventories (oil held in tanks).
Third, portfolio managers respond to a rise in interest rates by shifting out of commodity contracts and into treasury bills.
Finally, high interest strengthens domestic currency, thereby reducing the price of internationally traded commodities in domestic terms, even if the prices have not fallen in foreign terms.
Interest rates in US did not really rise in 2014, so most of these mechanisms are not yet directly at work, but speculators are thinking and shifting out of commodities in anticipation of future increased interest rates; the result has been to bring next year’s price decrease forward to today.
The fourth of the above mentioned canals, exchange rate, has already been operational. Prospect of monetary tightening coincides with moves by the ECB and the Bank of Japan toward enhanced monetary stimulus. The result has been an appreciation of dollar against the euro and the yen. That explains how so many commodity prices can be down in terms of dollars and up in terms of other currencies.
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