In a VoxEU post, Guillermo Calvo argues forcefully that rising commodity prices are the result of excess liquidity rather than supply and demand.
From VoxEU:
Here, one of the world’s leading macroeconomists argues that the explosion of commodity prices is the result of a very real global financial storm associated with excess liquidity in several non-G7 countries and nourished by low G7 central banks’ interest rates. The commodity price explosion is a harbinger of future inflation.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.
Commodity stockpiles
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).1 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,2 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.3 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.4 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!5
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.6 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.
Footnotes may be found here.
Dan Duncan 
Posts
Since most sovereign currency prodivers have zero or negative real rates, per recent comments by others on this blog, we will have massive over liquidity relative to assets or demand, surprise, surprise. And this is what the end of the gold systme has come to (not that I have any fondness to restore it): everyone’s money is loose, just some sums are looser than others. In the Thirties crash, everyone jacked up tariffs and most demanded payment in gold for a time. In the Great Dislocation of the Nineties and the Oughts, everyone is pumping vaporcred into their economies through great big hoses ‘out the door on the left’ of their central banks. An interesting experiment, but the living of it is lively, no?
I am sympathetic to most of Calvo’s argument, but there is a large undemonstrated assumption within it. He is saying, in essence, that SWFs are playing the commodity markets heavily: where is the proof? His reasoning for why they are/might be seems good, to offset bad yields on other assets, but it isn’t shown here, or well-described from what all information seems to be available, that it is _SWFs_ playing commodities heavily. Rather, it seems more nearly that it is the ibanks and hedgies playing commodities, though for essentially the same circumstances he attaches to sovereign funds. Hmmm.
But I really like this point Calvo makes: “The relevant money concept could be an aggregate involving M2 and Treasury Bills, for example.4 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!” If I follow what he is saying, then the T-bills swapped out by the Fed are more nearly cash-like than bond-like given present counterparty concerns on the swapped _out_ CDOs—and so functionally less ’sterilized’ than the face-for-mark values would imply. I think that is a very relevant concern, not least because top tier banks acquiring T-bills may be using them . . . to play commodities; certainly, they don’t appear to be using them much for ‘normal lendgin,’ of which little seems to be happening. Hmmmmmmmmm.