Hamilton: Negative Real Interest Rates Feeding Commodities Bubble

Jim Hamilton must feel like a Cassandra. At the Fed’s Jackson Hole conference last August, Hamilton gave a presentation that warned that the pricing of Fannie’s and Freddie’s debt was unwarranted given their highly leveraged balance sheets unless you believed that they really were full faith and credit obligations. He warned that assumption would be tested by the market and that the Fed would be the party that would have to come to the rescue.

Over the last three weeks, agency spreads have increased to levels not seen in a generation. Friday the Fed announced some new measures to shore up the market, including a one-month repo facility that seems a tad generous in how it treats agency-guaranteed collateral.

Now Hamilton is telling us what many suspect, namely, that the Fed’s interest rate policies are stoking the commodities boom to dangerously overheated levels. But Hamilton marshals data and arguments.

As we have said before, negative interest rates are a seriously bad idea, except (perhaps) on a short-term basis, say, six months. But the problem is that the monetary authorities, having painted themselves in a corner a bit by going so low, are then reluctant to increase rates until they have solid signs of economic recovery. Given the lag time for rate changes to have effect, this results in an overly long period of excessively low rates.

And negative rates fuel speculation. With money effectively free, anyone who can borrow on good terms has every incentive to find something to do with it. We had dot coms, housing, and now commodities, And debt-fueled expansions produce poor quality growth. Our latest growth period is the first in which household earnings failed to reach the high of the previous expansion. But the Fed seems incapable from learning from its experience.

From Econbrowser:

f 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.

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.

Percent change in commodity prices since Jan (click to enlarge)

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.

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?

Of course, Bernakne lacks the nerve; that’s precisely why commodities are acting the way they are.

And even if they give up half their gains since January, I bet most investors won’t be deterred (all the gains, conversely, would have a deterrent effect). As Hamilton points out, commodities are the best inflation hedge. There are good odds for US investors that the dollar will continue to depreciate, independent of the inflation outlook. Yes, you might get nailed and take a bad hit, and it could easily take a year to recover losses. But absent an economic collapse, the odds of continued tight supply and inexorable (over time) demand increases over the next few years appears to be sounder than any other bets on offer right now.

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  1. burnside

    Interesting and useful so far as it goes.

    But aren’t both of you considering what are in fact global commodities in a domestic context (fed)?

    You may be perfectly correct. On the other hand, the balance of the globe sometimes diverges from our way of seeing things.

  2. shargash

    The rise of a global economy is stressing all of our natural resources: water, arable land, minerals, energy, etc. Even so, many commodity traders are wedded to the idea of “the long-run equilibrium.”

    The fact is that no one has any idea of what the equilibrium price of almost any commodity is. For some, it may actually be much higher than the current “inflated” prices, and the equilibrium price may be going up over time.

    For example, the world is running out of phosphate rock. This is a critical resource for agriculture, and there simply isn’t going to be enough to go around. Not only that, but the amount available will go down every year. Potash is also in depletion, though not as far advanced as phosphate. Fertilizer shortages are already happening, which is going to reduce yields, at the same time that global population is increasing. The idea that farmers will just go out and plant more to offset yield declines and demand increases is just fantasy. The price of food is going to continue to go up, even though it is probably higher now than it “should” be.

    Global oil production (in “all liquids”) for the past 3 years is absolutely flat (a 0.02% increase from 2005 to 2007, with a slight drop in 2006). Global demand, on the other hand, has been growing over 3%/year. A flat supply with exponential demand growth is going to cause exponential increases in price.

    Some of the more common metals, such as copper and iron, might respond to increased price with increased supply. But for many of the earth’s most essential resources, it will take a huge capital investment just to slow the rate of depletion.

  3. Anonymous

    Now that The Fed is accepting manure as collateral, there will be a virtual gold rush to Texas from Wall Sreet!

    Yee Haw!

    In Texas, a significant issue is disposal of animal manures because Texas leads the nation with roughly 220 billion pounds of animal manures produced per year. Texas A&M University estimated the year 2000 manure production per animal

  4. Shalem

    The Yield Curve and the Mineral Bubble

    The Hidden Parameter in Interest Rates

    Executive summary:

    There is a strong link between the evolution of the market price of minerals and the shape of the yield curve.

    The idea is that given the shape of the yield curve the marginal cost of extraction of minerals becomes irrelevant to their market price as miners stop maximizing their output under constraint of the marginal cost of extraction.

    Profit maximization would have them trying to retain their minerals rather than extract them.

    The Hidden Parameter:

    The price of minerals has grown unabated since the Federal Reserve has started increasing short term rates above 2.5%.

    All of the minerals have grown together, which cannot be explained by the growth of the marginal price of extraction alone: no price increases have caused the price of any mineral to stop its growth as a result of an increased investment in exploration.

    This correlated increase in the price of minerals must be caused by a global parameter.

    Harvard Economics Professor Jeffrey Frankel made the hypothesis that a decrease in real interest rates (“real” rates exclude inflation) increases the demand for storable commodities.

    However during the increase of short term rates from 1% under the chairmanship of Alan Greenspan, inflation didn’t grow as fast as short term rates still minerals kept growing.

    Moreover any storage outside the ground would not be economically viable as the cost of storage would be added to the interest rates under this assumption the only storable commodity would be minerals.

    My hypothesis is different:

    Financial decisions are about choices:

    If you consider the minerals as short term assets, you come to the conclusion that miners, confronted with an inverted yield curve would, as a group, prefer to hoard their minerals in the ground where storage cost is almost free rather than sell them and invest the proceeds in long term assets.

    How else would we understand that the cost of oil was multiplied by 5 over such a short period with a low depletion of the proven reserves?

    How else would we understand that all the minerals saw their cost rising at the same period with a next to perfect correlation?

    How else would you explain the fact that the rise of minerals started shortly after the rise from 2.5% of short term interest rates by the Federal Reserve?

    At the same time the yield curve was under the influence of the famous Greenspan Conundrum, which caused the inversion of the yield curve.

    Should the yield curve on the U.S. dollar return to normal, as it did on Monday March 13, after the Bear Stearn bailout, the miners would stop hoarding their reserves in the ground and the prices should go down in the direction of their marginal cost of extraction.

    Should the yield curve stay normal or steep for a protracted period of time the price of commodities would reach their marginal price of extraction.

    According to my hypothesis, that price must be much lower than the expectation of all market participants.

    Because most of the hedge funds holding are outside the ground, they are not constrained by the marginal cost of extraction, should the price of mineral go down, we should see some overshooting, in particular with minerals with low industrial use: gold and silver.

    The correlation between the shape of the yield curve and the price of commodities is only one of the many overlooked signals that are embedded in the yield curve.

    Among others, it can give a precise timing of a possible systemic collapse through a Keynes’ Liquidity Trap.

    My model of the yield curve never gave a signal of a systemic collapse during the recent credit crisis: it has always forecasted that the Federal Reserve had sufficient room to rescue the market and the economy.

    Shalom Hamou
    Independent Yield Curve Special Advisor

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