« Gold standard discussion | Main
I guess now we know that the Fed has the tools to prevent deflation.
Recent research by Ke Tang and Wei Xiong documents that the correlation between the price changes of different commodities has been increasing over time. Here for example is the correlation between the changes in oil and copper prices. These two prices were essentially uncorrelated in 2001. Back then, in a week when oil prices went up, the price of copper was just as likely to go up as down. Over the last few years, however, the two prices have been much more likely to move together.
The recent positive correlation of course does not mean that an increase in the price of oil is what's causing the price of copper to go up. Instead, it just signifies that there are some common factors affecting the two markets in a similar way.
Another changing correlation over time is that between commodity prices and the exchange rate. Here for example is the correlation between the weekly change in the dollar price of oil and the weekly change in the number of dollars you'd need to buy one euro. In 2001, the correlation was actually negative for a while, because news of a weakening U.S. economy would cause both the dollar to depreciate and the dollar price of oil to fall. In recent years, however, the correlation is positive and quite strong. In the year ended September 1, a 1% depreciation of the dollar would typically be associated with a 1.3% increase in the dollar price of oil or copper.
The dollar strengthened against the euro with last spring's sovereign debt concerns, but has slid back dramatically since this summer. My view is that the anticipation of the Fed's latest quantitative easing measures has been a key factor in that slide.
It's interesting to look at how big an increase in commodity prices we would have expected given the size of the dollar depreciation and given the size of the recent correlation. It turns out that the recent run-up in oil prices is no mystery, given the magnitude of the dollar depreciation.
Ditto for copper prices. Note that the path for "predicted prices" in these two graphs is identical, since both are driven by the same realized exchange rate path.
I feel that there is a pretty strong case for interpreting the recent surge in commodity prices as a monetary phenomenon. Now that we know there's a response when the Fed pushes the QE pedal, the question is how far to go.
My view has been that the Fed needs to prevent a repeat of Japan's deflationary experience of the 1990s, but that it also needs to watch commodity prices as an early indicator that it's gone far enough in that objective. In terms of concrete advice, I would worry about the potential for the policy to do more harm than good if it results in the price of oil moving above $90 a barrel.
And we're uncomfortably close to that point already.
Posted by James Hamilton at November 10, 2010 07:29 AM
We see the same thing in stock prices - the decline in prices from April 2010 up to September 2010 corresponds is very much correlated with the timing of the end of QE1 (in March-April 2010) with the credible expectation that the Fed would initiate QE 2 beginning at the end of August 2010.
Posted by: Ironman at November 10, 2010 07:43 AM
Professor,
Oil over $90/bbl would be normal considering the current value of our currency. Expect oil in the $90 range before the end of next year and if QE2 is not offset by tax cuts or other supply side policy changes expect oil to be pushing (or above $100 by the end of next year).
Posted by: Ricardo at November 10, 2010 07:59 AM
I suppose this means that you diagree with Prof. Krugman on this question then.
Posted by: tyaresun at November 10, 2010 08:31 AM
tyaresun: Right.
Posted by: JDH at November 10, 2010 08:41 AM
The Fed can "watch commodity prices," but it is unlikely to do anything about them as long as unemployment remains high.
Exit from stimulus requires success in creating sustained real growth. Are you suggesting the Fed might scale back or abandon QE2 at a 9.5% unemployment rate? This seems highly unlikely. How would markets react? I suspect they would be quite upset indeed...
The point is that once Bernanke starts writing editorials extolling the virtues of the wealth effect, he is "on the hook" for the market's direction. Any large decline in stock prices, and ensuing rise in unemployment, would be blamed on a Fed policy "error".
Posted by: David Pearson at November 10, 2010 08:41 AM
JDH: I'm wondering what you think of this research on forex rates and commodity prices in the context of current commodity price run-ups.
http://www.voxeu.org/index.php?q=node/1631
I am not sure whether the series are cointegrated or whether there is a causal or merely forecasting effect, but presumably there is some transmission mechanism at work here.
Posted by: Robert Bell at November 10, 2010 08:43 AM
Where does the $90 a barrel comes from? Is it derived from some sort of model on the impact of oil price on consumption or investment?
Posted by: Rafael at November 10, 2010 08:57 AM
Robert Bell: Regardless of whether the series are cointegrated, the correlation between changes over a given fixed time interval is always a well defined concept and is what all of the analysis above uses.
Posted by: JDH at November 10, 2010 08:58 AM
I have never understood the logic behind core CPI as a measure of inflation. It excludes food and fuel from the index because they are volatile.
Isn't that precisely the wrong reason. Shouldn't the most volatile sectors of the economy be the first to feel pressure from inflation?
If I were looking for signs of inflation I would look in food fuel. And there they are. It worries me that Bernanke has not acknowledged their existence.
Posted by: Walter Sobchak at November 10, 2010 09:03 AM
http://bpp.mit.edu/daily-price-indexes/?country=USA
Will Commodity inflation lead to consumer inflation?
I do not think so with still so much private debt in the system.
Posted by: Adam at November 10, 2010 09:07 AM
Check out Billion Prices Project. It is real time data of prices for different countries including USA that are...
Statistics updated every day -5 million individual items -70 countries -Started in October of 2007 -Supermarkets, electronics, apparel, furniture, real estate, and more
http://bpp.mit.edu/
Posted by: Adam at November 10, 2010 09:18 AM
As you can see Ricardo, the fluctuations in the price of oil over the past year (move your cursor over the "1y" button) make your predictions (hunches or calculations) seem a little tame.
No question oil is an important commodity, but I wonder if there aren't others that are overlooked here. Food prices, (like oil, too volatile to count in the CPI we are told), seem to be moving up and the commodities associated with non-discretionary consumer good? With inflating (but of course unrecognized) food prices we get declining discretionary spending...so a step over that little deflationary hurdle, "the price will be lower tomorrow, so wait." to "no price will be low enough, so forget it." This splains why I am not shopping for the Bugatti. Hard to believe that the current compilation, ~1-2% inflation, in an economy that is 70% consumer spending, spending tied to house prices, prices now falling...is tied to reality. On the ground, it feels (and appears...and sounds and smells) like deflation, you know? Tis a variant of NoHousingBubbleHere maybe...or maybe the continuing denial.
Posted by: calmo at November 10, 2010 09:19 AM
The FED can indeed generate some extra inflation in the price of scarce resources. What it can't do is trigger inflation in resources that are not scarce: mainly real estate, and labor.
Surely you have to take some interest, James, in the pronounced changes observed in extraction rates for both Copper and Oil the past 10 years. Correlation between price and those rates is both strong, and sustained. Correlation is even further enhanced when one introduces declining resource quality, in particular declining ore grades of copper, and the notable introduction of non-conventional oil into the broader supply of conventional oil.
No question that reflationary policy in the current phase (Q3 2007 - Q3 2010) has enhanced USD denominated prices for commodities. But, how successful would this have been without the geological constraints for both copper and oil which are, by the way, quite well established now in the data.
Read Full Article »