You can argue that commodity prices are being driven higher by surging demand throughout the world. The problem with this thesis? The latest surge comes amid concerns about a weaker global economy. Or, you can argue that the lower U.S. dollar is to blame for higher commodity prices, since they are priced in U.S. dollars. Again, there's a problem: Commodity prices have risen far faster this year than the U.S. dollar has fallen.
James Hamilton, who writes the Econbrowser blog and is professor of economics at the University of California, San Diego, has another idea: Commodities are rising because U.S. interest rates are falling below the rate of inflation. When real rates are negative, the theory goes, they provide an incentive for speculation in storable commodities.
“One of the biggest surprises of the new year was how quickly the Federal Reserve lowered interest rates,” he said, noting as well that there are expectations for even more cuts ahead. “These revisions in expectations of Fed policy coincided quite precisely with the boom in commodity prices over that period.”
Last week's selloff of commodities also coincided with the Fed's decision to cut rates by 75 basis points (or three-quarters of a percentage point) – a big cut, no doubt, but not as much as the market had been expecting. Now, commodities are rebounding as expectations build for more cuts.
Jeffrey Frankel, a professor at Harvard University, has the same idea. “The developments of the last six months provided added support for a theory I have long favoured: real interest rates are an important determinant of real commodity prices,” he said in an article, published online.
High interest rates, he argues, reduce demand for storable commodities or increase the supply because they raise the incentive to extract them today rather than tomorrow, creating a glut; and, high real rates decrease the desire among companies to carry inventories because they are encouraged to shift out of spot commodity contracts and into things like Treasury bills. Lower rates have the opposite effect.
“As economic growth has slowed sharply, both in the U.S. and globally, the Fed has reduced interest rates, both nominal and real. Firms and investors have responded by shifting into commodities, not out,” Mr. Frankel said. “This is why commodity prices have resumed their upward march over the last six months, rather than reversing it.”
