Source: Federal Reserve Bank of St. Louis
Posted on 03/07/2008 4:30:11 PM PST by Gritty
If the Fed thinks that recent commodity price moves have nothing to do with their own actions, perhaps they should think again.
The yield on the 2-year Treasury fell yesterday to 1.5%. It's impossible to imagine that the average inflation rate over the next two years could be less than 2%, meaning that the real interest rate-- the nominal rate minus expected inflation-- has become unambiguously negative. Greg Mankiw is impressed that when you plot the implied real yield on the Treasury inflation indexed security maturing in 2010, you indeed get a graph of the real interest rate that has recently become quite negative. If there is no inflation over the next two years, you'd actually pay more in dollars to buy this security than you will receive back in coupons and principal. With inflation, you may make a nominal gain, but you're guaranteed to end up with less than you started in real terms.
Source: Federal Reserve Bank of St. Louis
Apart from the evidence of your lying eyes, does economic theory allow the possibility of a negative real interest rate? The answer, in an economy in which there is only a single consumption good that can be costlessly stored, is no. In such a world, you would never park your capital in the form of a Treasury asset that cost you one potato today and repaid you 0.99 potato next year, when you had available an opportunity instead to put a potato in your cupboard today and still have a perfectly good potato next year.
As Greg points out, in the actual U.S. economy we of course have thousands of goods and services, many of which cannot be stored at all, and most potatoes don't actually fare that well if you leave them in your cupboard for a year. But some items certainly can be stored pretty easily, and it is quite striking that the list of goods that are most readily stored is precisely the list of items whose price has been bid up most spectacularly since the real interest rate turned negative. The accompanying table displays the nominal price change over the last two months in the prices of the main commodities I could get my hands on through Webstract. Note these are the actual changes since January 1-- to quote these at an annual rate you'd multiply by about 6.
Percent change in commodity prices since January 1st
aluminum 29.2
barley 7.5
cocoa 25.9
coffee 23.5
copper 26.3
corn 21.2
cotton 32.0
gold 17.4
lead 32.7
oats 33.8
oil 6.8
silver 37.8
tin 15.5
wheat 32.7
zinc 20.5
Can the real interest rate be negative in a world where some but not all goods can be stored costlessly? Consider for illustration an economy with two goods, immortal potatoes and transient haircuts, with both items currently selling for $1 and both given equal weights in the CPI. If you put $2 into a 1-year TIPS with a real interest rate of -1% in that world, next year you'd have the ability to purchase 0.99 potatoes and 0.99 haircuts.
Why buy the TIPS when you could simply save the $2 in the form of 2 potatoes and still have those same 2 potatoes a year from now? If nothing else changes, and 2 potatoes were still worth 2 haircuts a year from now, everybody would want to do just that. If we were in long-run equilibrium before the real rate went negative, in response to a negative real interest rate, everybody would want to buy potatoes today as an investment vehicle. The price of potatoes today would have to be bid up to a point above the long-run equilibrium so that from here, potato prices are expected to rise less quickly than the price of hair cuts. Your 2 potatoes might be worth 2 haircuts today, but if they're only worth 1.96 haircuts next year, you might be just indifferent between an investment in TIPS or physically storing the commodity.
Now the real world is admittedly more complicated. Playing commodities is the farthest thing from a risk-free investment, and the calculation is more along the following lines. There is a downside risk from investing in commodities, and that downside risk grows the farther relative commodity prices move above their long-run equilibrium values. But the lower the real return available on assets such as Treasuries, the more investors are willing to face those risks, with negative real rates just producing an extreme version of that calculation. This of course is just a variant of Jeff Frankel's claim that interest rates are a prime driver of commodity prices.
I'm also willing to believe that there are a number of investors plunging into commodities today who don't know what they're doing. The economic fundamentals warrant a temporary increase in the relative price of commodities, for the reasons just given. Some less sophisticated investors see the surging commodity prices and jump on the bandwagon, thinking they're going to continue to go only up. To the extent that this is part of what's going on in the current market, it is just one more reason why commodity prices have responded as sharply as they did to negative real interest rates.
But wouldn't it be nice if instead of reasoning by "suppose that" and "what if", economists could resolve our disagreements like real scientists with controlled experiments? I have a modest suggestion along these lines.
With the Fed's target interest rate currently at 3.0%, a 1.5% two-year nominal Treasury yield implies that the market is expecting the Fed to cut rates a whole lot more and in a big hurry. Is 75 the new 25? asks Greg Ip-- we used to expect 25 basis points each meeting, now it seems to be 75.
So the Fed would clearly shock the markets by only bringing the rate down 25 basis points this month, to a new target of 2.75%. If Frankel is correct, we'd see an immediate plunge in commodity prices across the board. If we didn't see that price response, then the outcome of the experiment would have proved that the Fed is right in claiming that the recent commodity price moves have nothing to do with the FOMC.
So how about it, Ben? Wouldn't it be fun to collect a little high-quality data here? In the name of science?
Much of the commodity mnarket is worldwide. What the Fed does might affect the $US, but the other 80% of the planet has much more say in these matters.
The situation is even worse. Do you actually believe the inflation rate you are using when the money supply is increasing at a rate in excess of 15%.
Driving the interest rate lower is simply a mechanism to try to save the banks from their foray into derivatives and securitization of mortgage backed securities,etc.
It’s funny to see some of the comments from, for example, 1970 by the oil Arabs when they were complaining about the falling value of the $US. Cut and paste into 2008.
Silver is just incredible.
This afternoon heard an interesting interview on Public Radio about the high price of gas.
Apparently the really high price is not caused by an imbalance of supply and demand, but by extensive speculation in OIL FUTURES. According to the guest speaker, major institutional investors, pension funds, etc. have put huge amounts of money into oil futures. Not long ago, they had $9 billion invested there, now they have put around $250 billion in oil futures. This is what is driving the price so high. He also said in the next year the barrel price of oil could range for $150 to $30, the situation is so unstable.
This was not his recommendation, but it occurs to me that anyone who has their money in a pension fund or similar location where they have any influence, they could encourage this fund to invest somewhere else than oil futures. I guess we will have to decide which is better, lower oil prices or the best investment for our pension funds, or a search for another good investment that doesn’t artifically raise the price of oil.
A factor is that some refineries do not produce their own oil and have to buy it. Some go to the NYMEX now so spot prices are not as wild as they used to be. When the refiner needs feed stock he has to pay the going price although if he has some extra funds or is a little ahead he can buy futures contracts a few months ahead and maybe get a better price. Some of the speculators are these people who actually have to buy oil for their business.
I am beginning to really wonder if the whole goal is to collapse the US Economy... Everything being done by the Fed either devalues the dollar, or just furthers the sinking into debt...
I cannot help but think that we are headed for a SERIOUS recession - no matter what the Fed does. But they could quicken up the process, thus getting us back on the road to a healthy economy if they would just make the right decisions. Stop freely printing money like it is nothing but paper (oh, wait - it already is...), and running rates so low that debt just grows and grows (with no prospects of ever getting the debt paid back.
Yes it makes sense for people who need oil for their business to reserve some. My interest is the mind boggling figure for the institutional investors who had $9 billion invested not too long ago, and now have $250 billion invested. Do you know how this $250 billion investment compares with the amount invested by actual oil users?
You will have to furnish those numbers. I have heard that about 20% of the price is due to pure speculation.
“Everything being done by the Fed wither devalues the dollar, or just furthers the sinking into debt.”
Yes, and please have the government spend more money on bridges to knowhere, while neglecting less sexy expenditures on preserving existing bridges and other infrastructure. Too bad that repairing run down bridges, etc. does not create great photo-ops for elected reps. Oh, and by the way, lets have MORE tax cuts.
Well, one good thing, with the falling dollar, we will sell more things overseas, and have more foreign tourists on our shores. A few months ago the dollar EURO ratio was 1.34 and the Yen was 117. Now the Euro is 1.53 and the Yen is 102.
“about 20% of the price is due to pure speculation.”
Yes, that sounds about right. The interviewee said that without the big institutional jump, the oil would be about $80, rather than above $100.
You have about $100 trillion of infrastructure, most of it beyond its engineering lifetime. All of it needs to be knocked down and totally replaced with new and possibly better stuff. Or we could just declare this place farmed out and move on.
Sounds good to me. I really don’t know but wouldn’t be surprised if it were in the range 10% - 50%.
“it needs to be knocked down and totally replaced with new and possibly better stuff.”
Sounds like a plan. And these jobs cannot be outsourced. How do Hillary, McCain and Obama compare on this subject? Anyone know?
They should be interested in infrastructure. Maybe FedGov shouldn’t be involved in most of it, let the states and cities build what they need on their own. There’s no money either way. Pres Bush said that fixing the electrical grid might run $50 billion. That’s probably low and doesn’t include nifty things like converting everything to nuclear.
We could afford tax cuts if the government would quit wasting money... but as we know, that will never happen. Politicians are addicted to the power that comes with the checkbook (or would credit card be a better analogy?)
“Apparently the really high price is not caused by an imbalance of supply and demand, but by extensive speculation in OIL FUTURES. According to the guest speaker, major institutional investors, pension funds, etc. have put huge amounts of money into oil futures. Not long ago, they had $9 billion invested there, now they have put around $250 billion in oil futures. This is what is driving the price so high. He also said in the next year the barrel price of oil could range for $150 to $30, the situation is so unstable.”
That’s a pile of crap, do you think that pension funds could not have done the same thing 20 years ago. Different supply demand influences.
That just simply isn't true. You can't go in and buy 250 billion of futures contracts without having an offsetting seller of the same amount.
Scroll down to the light sweet crude contract. You'll see there are only 2.8 million or so outstanding contracts. Each contract is worth 1,000 barrels. Multiplied by 100 dollars / bbl that's doesn't come to 250 billion. (If my math is right.)
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