Thursday, February 21, 2008

The Next Big Bubble?

We live in interesting times. Oil and other commodity prices continue to rise even as global demand is presumably slowing down. Normally, one would expect commodity prices to slow down with a weakening global economy. What explains these developments? As The Economist notes, it cannot be supply conditions since they have not dramatically worsened recently. James Hamilton believes these developments may indicate the economy will be improving in the near future. The uptick in commodity prices is simply a reflection of their role as a leading economic indicator. Maybe he is correct, or maybe we are seeing the beginning of the next big monetary policy-generated bubble.

Jeffrey Frankel of Harvard University has shown there is an important negative relationship between real interest rates and real commodity prices, with causality running from the former to the latter. Here is one illustrative graph from his work:

One story Frankel tells is that as monetary policy lowers interest rates speculators shift out of treasury bills into commodity contracts. Hence, the recent rate cuts by the Fed are generating a movement of liquidity into commodities. This story gets even more traction when we consider that the other big asset markets--stocks and housing--that would normally attract this liquidity have already been bubbled and popped. Lquidity, then, is looking for a new home to make a bubble and commodities seem to fit the billing this time around.

While this view is only one interpretation of the recent surge in commodity prices, it strikes me as reasonable. If time shows it to be true, the Fed will have unwittingly lived up to its reputation as a serial bubble blower.


  1. Oil and other commodity prices continue to rise even as global demand is presumably slowing down.

    I don't know about other commodities, but thus far I haven't seen much evidence that world oil demand has fallen off much.

  2. Brian, the 'presumably' part is key. If the world economy is slowing down then global economic demand should be weakening too. In turn, the demand for oil should slow down as well. So there is a big 'if' here, and it may be the case as James Hamilton argues that the global economic outlook is improving. See this The Economist story for more on this perspective.

    The link you provide points to an interesting figure. It shows the supply of oil falling through 2012 as demand continues to grow. An obvious consequence,as figure shows, is higher price for oil. I am curious, though, why is the supply falling going forward? Peak oil or something? I would also question the steady, almost constant, increase in demand as prices soar.

  3. This is really quite easy to explain. We are in a liquidity bubble caused by financial deregulation and financial innovation of liquidity producing instruments and practices. As long as the global inflation trade is producing results, Wall Street traders will play a disproportionate role in ramming hard assets. To those who say the markets are working as they is true demand is up for commodities. But, much of the demand is artificial on two fronts. One, because of artificial global growth caused by 'financial' liquidity and two because of the demand from the paper in the futures markets. This has caused exogenous factors to affect pricing.

    When China's liquidity bust happens, and it will, this trade will bust as well. And, the rush to the door of investors with heretofore no experience in these markets will likely cause prices to bust.

    You don't need a scattergram chart or a detailed study to know liquidity, and by deduction, inflation, causes commodity inflation.

  4. Yes, I got the graph from The Oil Drum, your one-stop source for energy doom and gloom.

    [If you want to explore troubled economic waters, just consider the fallout of energy supply not meeting energy demand.]

    I can't speak for all commodities, but it certainly seems like the increase food prices (and oil?) is due to supply and demand, rather than investment portfolios being reshuffled.

  5. First stocks burst, then real estate, next it will be commodities.

    As far as China is concerned they're screwed too, if the USA isn't buying all the stuff they make.

    We've just set the stage for a world wide recession this time.

    Maybe someday it won't be this way, but for now when the USA gets a cold the rest of the world gets a fever. We are the world's biggest consumer market and when we go down they all go down with us.

    This speculation in oil screwing everyone and there's no need for it other than greed, just like with stocks, and real estate.

  6. The increase in food costs is also due to the stupdity of Al Gore's global warming baloney and therefore the need for ethanol as a fuel which just serves to raise food prices, causes starvation in poor countries and doesn't do anything for energy. It's the law of unintended consequences at work. Now we're paying higher prices for fuel and food.

  7. The USDA has estimated that in 2007 24% of the total U.S. corn crop was used to produce ethanol. When adjusted for exports, 29% of non-export corn was used for ethanol. That is expected to grow to a full 1/3 used for ethanol in 2008. Ethanol is the fastest growing end use for corn. Here is a link to the graph: