Rising US Real Interest Rates Imply Falling Commodity Prices

Real interest rates tend to have a negative effect on real prices of commodities: oil and gas, minerals, and agricultural commodities. One might hazard the prediction that US real interest rates are headed up, and therefore, other things equal, real commodity prices will decline.

The theory of the relationship between real interest rates and commodity prices is long-established. Personally, I like the “overshooting” formulation of the theory.

The econometric relationship is also pretty well-established, by statistical analyses that range from:
(i) simple correlations; to
(ii) regressions that control for other important determinants such as GDP and inventories in a “Carry Trade” model; to
(iii) high-frequency event studies that are not sensitive to the econometric problems of the regressions (namely, issues of causality and time series properties).

The simplest intuition behind the relationship is that the interest rate is a “cost of carrying” inventories. A rise in the interest rate reduces firms’ demand for holding inventories and therefore reduces the commodity price. Three other mechanisms operate, in addition to inventories. First, for a non-renewable resource, an increase in the interest rate increases the incentive to extract today, rather than leaving deposits in the ground for tomorrow. Second, for a commodities that have been “financialized,” an increase in the interest rate encourages institutional investors to shift out of the commodities asset class and into treasury bills. Third, for a commodity that is internationally traded, an increase in the domestic real interest rate causes a real appreciation of the domestic currency, which works to lower the domestic-currency price of the commodity.

I recently presented updated versions of my long-time research and commentary on this topic in two venues:

The National Minerals Information Center Seminar Series of the US Geological Survey, in Reston VA, Aug. 23 (click here for my ppt slides or pdf); and

the 2nd annual symposium of the JPM Center for Commodities at the University of Colorado, Denver CO, Aug. 15 (my ppt or pdf). My keynote at the latter received some coverage in the Chinese press.

What does all this have to say about the future path of commodity prices as of August 2018? Even though the random walk is a good rule for prediction at a short-term horizon, I hazard a bolder guess at the medium horizon. The current US combination of loose fiscal policy (tax cuts and increased federal spending) and normalization of monetary policy (more increases in short-term interest rates from the Fed) suggests that real interest rates and the value of the dollar may go up. This monetary-fiscal mix is reminiscent of the Volcker-Reagan policy combination in 1984. The overshooting theory predicts that, as a result, real commodity prices are headed down.

References

The overshooting model: Real interest rates influence real commodity prices.

“Expectations and Commodity Price Dynamics: The Overshooting Model,” 1986, American Journal of Agricultural Economics68, no. 2, May, pp.344-48.

“Commodity Prices, Money Surprises, and Fed Credibility,” with Gikas Hardouvelis, 1985, Journal of Money, Credit & Banking 17, no.4, Nov., 427-38.

Determinants of commodity prices in non-$ currencies

“The Effect of Monetary Policy on Real Commodity Prices”, 2008, Chapter 7 in Asset Prices and Monetary Policy, John Campbell, ed. (U.Chicago Press): 291-327. NBER WP 12713.

The “carry trade” model: Determinants of convenience yield matter too.

“Determination of Agricultural and Mineral Commodity Prices,” with Andrew Rose, 2010, Chapter 1in Inflation in an Era of Relative Price Shocks (Reserve Bank of Australia: Sydney), pp. 9-51. HKS RWP 10-038.

“Effects of Speculation and Interest Rates in a “Carry Trade” Model of Commodity Prices,” 2014, Journal of International Money and Finance, 42,pp. 88-112. HKS RWP13-022.For the updated results, thanks are due Shruti Lakhtakia and Marco Martinez.