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.
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.
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.