Federal Reserve Chairman Ben Bernanke delivered a speech yesterday to the International Monetary Conference in Atlanta, Georgia. It turns out, according to Bernanke, that “accommodative” monetary policy is the perfect elixir–perhaps the only known to mankind–in that it can cure the economic patient without producing any untoward side effects. Let’s examine in a bit of detail some of what Mr. Bernanke said, particularly regarding commodity prices and Federal Reserve monetary policy:
The basic facts are familiar. Oil prices have risen significantly, with the spot price of West Texas Intermediate crude oil near $100 per barrel as of the end of last week, up nearly 40 percent from a year ago. Proportionally, prices of corn and wheat have risen even more, roughly doubling over the past year. And prices of industrial metals have increased notably as well, with aluminum and copper prices up about one-third over the past 12 months. When the price of any product moves sharply, the economist’s first instinct is to look for changes in the supply of or demand for that product. And indeed, the recent increase in commodity prices appears largely to be the result of the same factors that drove commodity prices higher throughout much of the past decade: strong gains in global demand that have not been met with commensurate increases in supply.
When the price of a group of products that have as basically their only connection the fact that all are fungible (a bushel of wheat is a bushel of wheat; a pound of pork bellies is a pound of pork bellies; a barrel of oil is a barrel of oil, no matter where each are produced or consumed) and traded on international markets, the first place one might wish to look is not to the supply and demand metrics for a whole category of unrelated products, but to the metric–the only other commonly-shared attribute–through which the group of products is priced. The US dollar is the international reserve currency, so internationally-traded commodities are priced in dollars. If commodities are increasing in price across the board, then perhaps prices are being driven higher by a decrease in the value of dollars.
In fact, international commodities, priced in dollars as they are, rose and fell according to the exchange value of the dollar, as the following graphs from FRED (the database maintained by the St. Louis Federal Reserve Bank) clearly indicate:
Not to be dissuaded by facts pointing to the weak dollar as driving commodities prices, Bernanke goes into a long-winded explanation that really, it’s not the dollar, it’s the expansion in global demand:
From 2002 to 2008, a period of sustained increases in commodity prices, world economic activity registered its fastest pace of expansion in decades, rising at an average rate of about 4-1/2 percent per year. This impressive performance was led by the emerging and developing economies, where real activity expanded at a remarkable 7 percent per annum. The emerging market economies have likewise led the way in the recovery from the global financial crisis: From 2008 to 2010, real gross domestic product (GDP) rose cumulatively by about 10 percent in the emerging market economies even as GDP was essentially unchanged, on net, in the advanced economies.
Draw a mental line of the average slope in the top graph from 2002 to 2008, the period Bernanke cites as reflecting sustained increases in commodities prices due to expanding demand and constricting supply. The value of the dollar went down, the price of commodities went up. A tighter correlation would be hard to imagine. Even were demand expanding, it couldn’t possibly have been expanding over all commodities, nor so tightly correlated to the value of dollars in foreign exchange markets.
But according to Bernanke, the increased demand could not be answered through expanded supply, try as this old world might:
Production shortfalls have plagued many other commodities as well. Agricultural output has been hard hit by a spate of bad weather around the globe. For example, last summer’s drought in Russia severely reduced that country’s wheat crop. In the United States, high temperatures significantly impaired the U.S. corn crop last fall, and dry conditions are currently hurting the wheat crop in Kansas. Over the past year, droughts have also afflicted Argentina, China, and France. Fortunately, the lag between planting and harvesting for many crops is relatively short; thus, if more-typical weather patterns resume, supplies of agricultural commodities should rebound, thereby reducing the pressure on prices.
Channeling his inner Krugman, Bernanke should have just gone ahead and blamed the price increases on global warming. As I discussed in a post Monday, the world has generally had no trouble keeping up with growing food demand. Not every year in the last decade saw a surplus, neither did more than one or two see a shortfall, but there were enough surpluses that excess stockpiles of grains worldwide were roughly equal at the start and at the end of the decade.
Of course, this is only pertinent to a discussion of agricultural commodities whose supply situation is beholden somewhat to the vicissitudes of nature. Demand steadily grows for agriculture products, but supply overshoots and undershoots according to a number of factors (not just global warming). So far as industrial metals and chemicals go, supply is stable, while demand varies drastically according to the aggregate level of economic activity. Yet basically all commodities marched in lockstep upwards in price from 2002–2008, until falling off the cliff in 2009, and have now, in most cases, recovered or exceeded their previous price levels.
But shouldn’t the exception prove Bernanke’s rule that supply and demand metrics have caused the outrageous spikes up and down in commodities prices? So far as agricultural products, with very stable demand (people have to eat, no matter the state of economic activity) and reasonably stable supply, supply and demand fluctuations could not possibly explain why wheat and corn prices have tripled and doubled since their nadir in 2009. But according to Bernanke, the markets for lumber and natural gas proves that it’s the supply and demand, stupid:
Not all commodity prices have increased, illustrating the point that supply and demand conditions can vary across markets. For example, prices for both lumber and natural gas are currently near their levels of the early 2000s. The demand for lumber has been curtailed by weakness in the U.S. construction sector, while the supply of natural gas in the United States has been increased by significant innovations in extraction techniques.5
What lumber and natural gas instead prove is that supply and demand metrics can overpower monetary hijinks. If demand declines enough, no amount of money-printing can rescue it. Ask Japan. Demand for lumber is intimately tied to the market for newly-built homes, which has plummeted in the US to levels not seen since statistics on such things have been kept (the early 1960’s). Natural gas is not an internationally-traded commodity with an international market large enough to matter. Natural gas is expensive to transport (as Bernanke later acknowledges), and so its price is driven by domestic supply and demand metrics, as well as the purchasing power of the dollar domestically, which has not declined nearly as much as it has internationally, constrained as domestic prices are by a lack of demand growth. Even inflationary monetary policy has its limitations.
But Mr. Bernanke wants it made clear that the Fed’s monetary hijinks have not caused commodities price increases:
While supply and demand fundamentals surely account for most of the recent movements in commodity prices, some observers have attributed a significant portion of the run-up in prices to Federal Reserve policies, over and above the effects of those policies on U.S. economic growth. For example, some have argued that accommodative U.S. monetary policy has driven down the foreign exchange value of the dollar, thereby boosting the dollar price of commodities. Indeed, since February 2009, the trade-weighted dollar has fallen by about 15 percent. However, since February 2009, oil prices have risen 160 percent and nonfuel commodity prices are up by about 80 percent, implying that the dollar’s decline can explain, at most, only a small part of the rise in oil and other commodity prices; indeed, commodity prices have risen dramatically when measured in terms of any of the world’s major currencies, not just the dollar. But even this calculation overstates the role of monetary policy, as many factors other than monetary policy affect the value of the dollar. For example, the decline in the dollar since February 2009 that I just noted followed a comparable increase in the dollar, which largely reflected flight-to-safety flows triggered by the financial crisis in the latter half of 2008; the dollar’s decline since then in substantial part reflects the reversal of those flows as the crisis eased. Slow growth in the United States and a persistent trade deficit are additional, more fundamental sources of recent declines in the dollar’s value; in particular, as the United States is a major oil importer, any geopolitical or other shock that increases the global price of oil will worsen our trade balance and economic outlook, which tends to depress the dollar. In this case, the direction of causality runs from commodity prices to the dollar rather than the other way around. The best way for the Federal Reserve to support the fundamental value of the dollar in the medium term is to pursue our dual mandate of maximum employment and price stability, and we will certainly do that.
Did you catch that? Logic is apparently not the life of Federal Reserve Chairmen, either. So far as commodity prices impair economic performance in the US, they drive the value of the dollar down, because of the anticipated effect higher commodities prices will have on economic performance. Yet, it was economic panic, i.e., the prospect of poor economic performance, that drove the dollar higher in late 2009 (during which time commodities prices plummeted), from which it has now declined as a reversal of those flight-to-safety flows. Thus the dollar goes down because of poor economic prospects due to higher commodities prices; it goes down in a flight away from safety due to better economic prospects coming out of recession; it only goes up when there is a panic; and finally, commodities prices drive the dollar’s value, not the other way around. Really, I couldn’t make this up if I tried.
But in case anyone were wondering that the Fed’s actions had really any bearing on economic performance, considering Bernanke’s claim that it has had only benign effects on commodities markets, he offers a best-of- all-world’s view of the Fed’s monetary shenanigans that only an economic Pangloss, or a Fed chairman, could appreciate:
The U.S. economy is recovering from both the worst financial crisis and the most severe housing bust since the Great Depression, and it faces additional headwinds ranging from the effects of the Japanese disaster to global pressures in commodity markets. In this context, monetary policy cannot be a panacea. Still, the Federal Reserve’s actions in recent years have doubtless helped stabilize the financial system, ease credit and financial conditions, guard against deflation, and promote economic recovery. All of this has been accomplished, I should note, at no net cost to the federal budget or to the U.S. taxpayer.
It did all that, but without impacting the price of internationally-traded commodities one little bit? What a powerful drug is this accommodative monetary policy that Mr. Bernanke prescribes!
What has really happened? The Fed has cost untold trillions to the US taxpayers; in the taxation that devaluation of the currency implies; in the future claim on production that creating money representing nothing implies, and through the assumption of massive liabilities attendant to keeping the American economic Ponzi scheme afloat. As Albert J Nock observed long before the world had been exposed to monetarist economic theory and Messrs. Greenspan and Bernanke, money can’t buy anything. Only goods and services buy things. Money is just a medium through which the value of one good or service is related to the value of another.
Monkeying with the quantity and availability of the medium changes nothing long-term, but can cause short-run (generally less than two years) friction in markets as they adjust to prices that have changed in response to a change in the medium. After the adjustment has worked its way through the system, the relative supply and demand metrics for goods and services re-emerges, and values adjust accordingly. In the process of adjustment, the illusory expansion in demand creates excessive supply, which at some point grows so unbearably large that it breaks through the illusion, forcing demand and prices down. This process is even now underway, and is reflected in a gathering decline in economic activity, but its ultimate resolution is continually being pushed to the future by continued accommodative monetary policy, or the expectation of its further continuance (the Greenspan/Bernanke Put), which affects an economy about like birth control pills affect a woman’s body, always tricking the economy into thinking it to be pregnant with the prospect of growth.
When it finally breaks; when illusory demand is revealed for what it is, then starts Great Recession II. Unfortunately, the Fed’s been dosing the patient with so much accommodative elixir that the medicine cabinet will be bare. I think the flight to safety flows the dollar enjoyed last time might just head in a different direction this time around.