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Financial Speculation in Commodity Markets
by Dr. Benn Steil, Director of International Economics; Council on Foreign Relation

statement before the
Committee on Homeland Security and Governmental Affairs
United States Senate

May 20, 2008

Thank you Chairman Lieberman, Ranking Member Collins, and members of the Committee for the opportunity to present to you this morning my views on the causes of rising financial speculation in commodities markets.

usagoldThe sharp recent rises in global commodities prices, particularly in the energy and agricultural sectors, is undoubtedly causing hardship for many Americans, and is indeed threatening the health of many millions in developing countries. There is also no doubt that these price rises have been accompanied by a corresponding rise in interest from institutional investors in commodities as an asset class. The value of commodity index investments, for example, has grown by about 1/3 since the beginning of the year, to more than $250 billion.

Certainly, much of this inflow is "speculative," in the sense that it is anticipating future supply constraints and robust demand. Both have been very much in evidence in recent years, and to the extent that speculation is driven by such factors it is playing a proper and indeed important role; that is, signaling the need to expand investment in production capacity, and providing liquidity to hedgers.

If this inflow is "manipulative," on the other hand, it should be a matter of immediate regulatory concern. But there is very little evidence that it is. Low and declining levels of inventory for major food crops, for example, indicate no potentially manipulative hoarding going on in that sector. In the crude oil futures market, the evidence suggests that changes in speculative positions follow the reactions of commercial traders to relevant news, so that commercial rather than speculative position changes are driving price changes.

So-called "fundamental" factors, related directly to supply of and demand for specific commodities, can certainly account for a goodly portion of the run-up in prices in recent years.

The supply of global farm acreage and crop output is shrinking relative to a global population that is rising both in size and wealth.

Rapidly growing demand from China is certainly part of the equation. Demand from China accounts for about 30% of the increase in crude oil demand over the past decade. A 6% rise in base metals demand last year was driven by a 32% increase in demand from China.

The tripling in oil prices since 2004 has spurred the production of biofuels, like corn-based ethanol, which has in turn contributed to record prices in corn and rival grains. These in turn have made products whose production relies on grain-based feed, such as milk and eggs, more expensive. This year, about 30% of US corn production will go into ethanol, rather than into world food and feed markets.

While all of these factors are acting to constrain supply or boost demand, governments around the world exacerbate these effects through public policy. Governments subsidize consumption of agricultural staples and energy products, for example, with the effect that demand does not moderate as it should. Governments have also been imposing agricultural export tariffs and bans, with the unintended consequence that farmers are motivated to reduce supply.

Yet all these fundamental factors, as important as they are, cannot explain the magnitude of price rises in recent years. The stories about global population growth and the rise of China, for example, are by now very old.

Many have recognized this, and have therefore asserted that we are experiencing a "commodities bubble." This conclusion, however, presumes that the US dollar, which the world uses to price and trade commodities, is a fixed unit of measurement, like an inch or an ounce. Yet it is not, and, worryingly, it has become less so in recent years. Whereas the prices of oil and wheat measured in dollars have soared over the course of this decade, they have, on the other hand, been remarkably stable when measured in terms of gold -- gold having been the foundation of the world's monetary system until 1971.

gold currency pricing

It is therefore reasonable to conclude not that we are a experiencing a commodities bubble, but rather the end of what might usefully be termed a "currency bubble."

The early 1980s witnessed the painful restoration of the global credibility of the dollar under the tight-money policy of the Paul Volcker-led Federal Reserve. We reaped the benefits of this achievement in the subsequent decade. The period of the 1990s through the early part of this decade was a golden age for the dollar. Investors around the world bought up dollar-denominated assets and central banks sold off their gold reserves, believing they were no longer necessary or desirable, allowing our country to enjoy the fruits of a sustained period of low interest rates and low inflation. But the Federal Reserve pushed rates too low and held them low for too long, and has since last autumn been exceptionally aggressive in driving them well below the rate of inflation. The Federal Funds Rate now stands at 2%, while consumer price inflation is near 4% and wholesale price inflation near 7%. More worrying, the latest survey from Reuters and the University of Michigan found that consumers' one-year inflation expectations have risen to 5.2%, up from 4.8% in April and 4.3% in March.

The dollar's value against the euro being tightly linked to the interest rate differential between the currencies, investors have shifted funds dramatically from low-yielding dollars to higher-yielding euros in recent years. Much more worrying, however, the correlation between dollar depreciation and commodities prices has become dramatically more pronounced since 2007, as illustrated in the figure below.

dollar-commodity correlation

Institutional investors around the world ­ prominent among them, large US public pension schemes, such as CalPERS ­ have come to view commodities as part of a rapidly growing asset class devoted to inflation-protection.

Longer-term, governments themselves may actually fuel the upward commodities price trend by diversifying central bank reserves into commodities as a way to avoid precipitating further depreciation (vis-à-vis other currencies) of their existing huge stocks of dollar-denominated assets -- in particular, US Treasurys.

What happens to commodities investment, and therefore commodities prices, going forward is therefore heavily dependent on the path of inflation and inflation expectations, and this path is itself critically dependent on developments in US monetary policy.

What policy measures, then, could help to relieve the damaging upward pressure on global commodities prices? I would identify two broad areas that merit attention.

First, we and other nations need to revisit honestly and objectively the range of subsidies and taxes we apply to encourage or discourage consumption and investment in the agricultural and energy sectors. The mix is far from optimal, and is becoming more damaging over time.

Second, more of the burden of dealing with the fallout from the mortgage and interbank credit crisis should be moved "on balance sheet." That is, Congress should look to targeted, explicitly funded, and market-oriented interventions to help revive the credit markets, which in turn will help revive the broader economy. To date, far too much of the burden has been borne by monetary policy, which is threatening to cause higher inflation, and leading individuals and institutions around the world to question whether the dollar will remain a credible long-term store of value. One highly undesirable result of this is soaring global commodity prices.

Senate Source 05/20/2008

See also...

Is the Dollar Doomed?
A presentation by Dr. Benn Steil at the May 12-13, 2008 New York Hard Assets Investment Conference

(excerpts, documented at Resource Investor)

Is this Federal Reserve dedicated to price stability? Well, we have a Fed Funds Rate at 2%. We've got consumer price inflation at 4%; wholesale price inflation at 7%; a broad measure of U.S. money to supply growth. M3, interestingly enough, is no longer calculated by the Federal Reserve. We rely on private estimates going at around 17%. It is not surprising that people around the world are beginning to lose faith in this fiat dollar. So I think it's a mistake to characterize what we're seeing now as somehow a commodity's bubble...

The U.S. dollar has not looked like a great store of value over, say, the past two decades. Much more importantly, it hasn't looked like a very good store of value over the course of this decade, vis-à-vis hard assets...

...given that our Fed has been very much acting like a lender of last resort lately, trying to support liquidity in the market, participating in a bail-out of Bear Stearns, people in this country may be beginning to get very nervous about this, about how much money is being printed. And if they do become very nervous, they will ultimately behave just like people around most of the world. That is, when the Fed tries to behave as a lender of last resort, people will go to their financial institutions, withdraw their money, and then sell it for euros or some other currency, or perhaps for hard assets...

What if central banks around the world were to start increasing their holdings of euros very significantly? What would that mean? Well, that would mean further significant upward pressure on the euro. ... If that were to happen, think about what the political reaction in Europe would be. The pressure on the European Central Bank to relax monetary policy would be utterly enormous..
Also, very recently, one of the major ratings agencies threatened to downgrade U.S. government dollar-denominated debt because of our long-term fiscal obligations. But if you look at the situation in Europe, certainly it's at least as dire as it is here.
So the euro is not a natural alternative to the dollar. People trading in euros has its own problems, which probably means that the euro is not a particularly attractive direct alternative to the dollar.
So what would come next? Well, if you go down the line of currencies around the world, you don't find many attractive opportunities. And that's why I say if the world were to give up on dollars and give up on euros, they'd probably go back to the old standby, which is gold. And I don't mean by gold, government run gold standard, like we had in the late 19th century. That's politically impossible. Governments will never be willing to subordinate their policies to the constraints of a hard commodity ever again... So how could gold make a revival as a sort of international money? Well, we don't actually need a government run gold standard anymore...

...since people have always had confidence in gold as a long-term store of value, there's no reason why it couldn't play that role.

Click here to access a page by Resource Investor with an audio file and transcript of this presentation.

Dr. Benn Steil
Director of International Economics
Council on Foreign Relations
58 East 68th St, New York, NY 10065
Tel 212 434 9622 Fax 212 434 9875 Email bsteil@cfr.org

Dr. Benn Steil is Director of International Economics and a Senior Fellow at the Council on Foreign Relations in New York. He is a co-founder and managing member of Efficient Frontiers, LLC, and also editor of International Finance. Prior to his joining the Council in 1999, he was Director of the International Economics Programme at the Royal Institute of International Affairs in London.  He came to the Institute in 1992 from a Lloyd's of London Tercentenary Research Fellowship at Nuffield College, Oxford, where he received his PhD in Economics. Dr. Steil has written and spoken widely on international finance, securities trading, and market regulation.  His research and market commentary are regularly covered in publications such as the Wall Street Journal, Financial Times, New York Times, International Herald Tribune, The Economist, Barron's, Business Week, Crain's, Forbes, Fortune, Newsweek, Time, and Reuters and Bloomberg outlets. Dr. Steil is co-author of Financial Statecraft: The Role of Financial Markets in American Foreign Policy (Yale University Press, 2006).

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