Saturday, March 29, 2008

Why Commodity Prices are High

The commodity price boom has been attributed to Asian (specifically Chinese) demand, but I include commodities in our portfolios for a different reason. Commodities are the canary in the coal mine of inflation and our mandate for our portfolios is to protect purchasing power. This article at by Jeffrey Frankel ( explains why commodities have been rising so dramatically since the Fed started slashing interest rates:

How to explain commodity prices go up while the economy turns down? If strong economic growth is not the explanation for the large increases since 2001 in prices of virtually all commodities, then what is?

One wouldn’t want to try to reduce commodity markets to a single factor, nor to claim proof of any theory by a single data point. Nevertheless, 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.

High interest rates reduce the demand for storable commodities, or increase the supply, through a variety of channels:

by increasing the incentive for extraction today rather than tomorrow (think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled)

by decreasing firms’ desire to carry inventories (think of oil inventories held in tanks), by encouraging speculators to shift out of spot commodity contracts, and into treasury bills.

Commodity prices are rising because of monetary factors, not because of growth or peak oil or any other explanation. And that monetary policy is inflationary.

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