From: Rakesh Bhandari (bhandari@BERKELEY.EDU)
Date: Tue Nov 16 2004 - 10:26:43 EST
This is the html version of the file
http://ksghome.harvard.edu/~jfrankel/Greenspans_strategic_reserve.pdf.
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The Dismal Science: Mr. Greenspan's Strategic Reserve
Susan Lee. Wall Street Journal. (Eastern edition). New York, N.Y.:
Sep 20, 2004. pg. A.21
There is little doubt that the Federal Reserve is about to pump up
the federal-funds rate by 25 basis points to
1.75% as part of Alan Greenspan's kabuki dance to control inflation.
It is also a textbook response to oil prices
that are now about 35% more expensive than they were at the beginning
of the year. But the truly deft and
sneaky aspect of the increase is that higher oil prices themselves
are probably a result of Mr. Greenspan's really
loose monetary policy.
This explanation of the current situation is in fact a mirror image
of the one identified by Jeffrey A. Frankel,
economist at Harvard's Kennedy School of Government, in the 1980s.
("Expectations and Commodity Price
Dynamics: The Overshooting Model," available online.) Back then, real
interest rates were high and prices for
commodities, including oil, were in a swoon.
Mr. Frankel's argument was simple and elegant. Changes in the money
supply resulted in changes in real
interest rates and the first impact of these changes was seen in
prices for commodities. Thus, as real rates went
up, commodity prices went down. Consider, then, Mr. Frankel's model
applied to what has been happening
more recently.
As Mr. Greenspan engineered low real interest rates in 2001-04, the
prices of commodities, particularly oil and
other minerals, started to climb in advance of a general price
increase. Why? The prices of some things, like
manufactured goods, are sticky. They don't change very fast because
they may be fixed by explicit contracts,
there may be imperfect information, or businesspeople may want to
postpone the costs attached to changing
their prices. Commodity prices, on the other hand, are way more
flexible. Since commodity prices are
determined by trading on fast-moving auction markets, they respond
more swiftly to interest-rate expectations
and monetary fluctuations than do consumer prices.
But, in the short run, these faster-adjusting markets overshoot their
long-run equilibrium prices. Since some
prices are sticky -- or lag behind -- the prices that are free to
move, like commodity prices, must move in an
exaggerated fashion in order to compensate for the laggards. Thus,
commodity prices overshoot their new
equilibrium in order to generate an expectation of future
depreciation that is sufficient to offset lower interest
rates. This skyrocket effect will vanish in the long run.
So Mr. Greenspan's loose monetary policy created low nominal interest
rates and an increase in the expected
economy-wide inflation rate. Both caused investors to shift out of
money and other financial investments into
more attractive assets like commodities. In other words, the
expectation that prices will increase, and thus that
the value of money will fall, causes investors to shift out of money
today; at the same time, the demand for --
and therefore the prices of -- alternative assets, like commodities,
increases today. Mr. Frankel says: "As a
consequence of the increased demand for commodities, expected future
inflation has a positive effect on
commodity prices in the present."
And the fact that commodity prices overshoot their long-run value is
necessary for a rational market anticipation
of future depreciation to balance the lower, real interest rate.
Of course, as Mr. Frankel points out, there are other obvious and
specific things active in the oil market. On the
demand side, world appetite for oil, fueled by China and India, has
been gangbusters. (Also important at the
margin has been the U.S. policy to fill the Strategic Petroleum
Reserve.) As a result, recent global demand for
oil has been growing at over 3% as opposed to its average of a touch
under 2% over the past decade. And on the
supply side, there have been anxieties about the steadiness of
production coming from Russia, Venezuela,
Nigeria and Iraq.
None of these things is under Mr. Greenspan's control, to be sure,
but his ultra-low interest-rate policy did
prompt a burst of speculation in the form of the carry trade.
Investors, mostly hedge funds, borrowed U.S.
dollars to buy higher-yielding oil. Ultra-low interest rates also
made it cheaper for speculators to float giant
tankers in the middle of the ocean, waiting until prices reached a
peak. (Low rates drive this kind of inventory
holding in two ways. If the cost of storage is relatively cheap it
makes sense to leave the oil in tankers, hoping
the price will go up. Similarly, lower interest rates lower the
opportunity costs of making other investments.)
The delicious irony of course is that while Mr. Greenspan blames high
oil prices for the recent "soft patch" in
the economy, he is, in fact, blaming himself.
But after lowering interest rates 13 times, starting in 2001, the Fed
began to tighten in June, twice raising the
federal-funds rate by 25 basis points. As a tighter monetary policy
raises nominal interest rates above the
expected rate of inflation, oil prices will fall as speculators cut
inventories, producers pump oil faster, and
investors shift out of oil into financial instruments.
Even though real interest rates are negative, the expectation of
higher rates has already caused oil prices to fall.
Speculators started bailing out of oil in August, selling those
floating, off- shore cargoes. Likewise, hedge funds
have been unwinding their carry trade positions. And, thus, oil
prices have declined since hitting a high of
almost $50 a barrel in August.
Of course nobody can predict with daily accuracy what will happen to
oil prices if the Fed nudges up the
federal-funds rate tomorrow. Even with some of the speculative
premium gone, there is still a big, fat risk
premium in the market. But one thing is for sure -- it will be a tiny
step toward undoing the spike that Mr.
Greenspan has nurtured.
---
Ms. Lee is a member of the Journal's editorial board.
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