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Driving Oil Higher With Low Interest Rates

There is theory that low interest rates drive up commodity prices. And the converse, high interest rates drive down commodity prices. Commodities are things like oil, corn, soybeans and wheat.

This theory has been around a while, at least a decade or so and there is statistical evidence to back it up. It’s all the buzz on the economics blogs. Honestly I don’t understand the mechanisms, and I wonder if many of the people buzzing about this theory do either, since they are all citing the same examples with no underlying explanations.

The evidence cited is a graph:

This may look like a scatter plot but the correlation is statistically significant.

The mechanisms given are:

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.

All three mechanisms work to reduce the market price of commodities, as happened when real interest rates where high in the early 1980s. A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories, and raising commodity prices, as happened in the 1970s, and again during 2001-2004. It’s the original “carry trade.” The theoretical model can be summarized as follows:

This is from the Jeff Frankels Economics blog. Over at Harvard.

The only way I can explain this and this is my explanation, only mine:

If the interest rates are low, than the cost of carrying inventory is deceased, allowing companies not to mind carrying larger inventories, larger inventories decease supply available to the consumers, driving prices up. Got that? Whereas high interest rates increase the cost of inventories to the point where companies have every incentive to get the commodities to market as fast as possible. Of course this seems to be a short term effect, in my mind. A dismal science indeed.

I post this because our Federal Reserve is pumping cash in to the credit markets via crashing interest rates. According to this theory our commodity prices will skyrocket.

Well, they already have and if this theory holds true, they will be somewhere around Pluto before years end.

I have to ask is the medicine worse than the illness?

In fairness I should mention the Federal Reserve does not believe in this theory, obviously.

Another point to make in all of this is: Don’t think the Fed’s meddling in our economy is done by a set of hard and fast and proven rules.  They may be some of the best minds of our time, but, their models may reflect or model the last recession.   And may not be accurate for this recession.

Additionally this is an election year, and we do know that politics will influence policy.

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