Predicting the End of the Commodity Bubble

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For once in history, Russia appears to be on the right side of a global price trend. As one of the world's major producers of commodities -- not least oil and gas -- the country is reaping a windfall as commodity prices soar worldwide. But is this price boom another bubble that will burst just as we have seen in real estate markets in a number of countries? Is Russia prepared to deal with the consequences of price volatility?

This is not an academic point. Many still remember the role that declines in oil prices had on weakening Mikhail Gorbachev's Soviet regime in the 1980s and on triggering the 1998 financial crisis.

A cautionary tale from Africa in the 1970s underscores the problem. Some may recall that the original supply shock in oil prices following the Arab-Israeli War of late 1973 led to a loosening of monetary policy in the United States and other Western countries in an effort to offset the deflationary impact of the shock. This, in turn, led to a drastic increase in almost all commodity prices, including energy, metals and agriculture. The result was stagflation, and this continued until Paul Volcker, who became head of the U.S. Federal Reserve in 1979, tightened liquidity. Commodity prices went into a tailspin, and those countries -- notably in Africa -- that assumed high prices would become a new permanent equilibrium embarked on ambitious, even grandiose, spending and borrowing. They soon found themselves in a tragic debt trap from which few even now have been able to extract themselves.

Is history about to repeat itself? And could Russia be an unintended victim of a commodity price bubble that will soon burst?

You have to wonder when looking at recent price trends. It is not just the headline numbers concerning historic peaks for oil and gold. Oil prices have risen from $66 per barrel a year ago to $101 on April 1. Gold rose by 37 percent over the same period. Other commodities have followed suit. In the last year, wheat prices have risen by a third, rice prices have doubled and copper rose by 22 percent. Overall, the Economist commodity price index is up 32 percent in dollar terms.

These price spikes have occurred even in the absence of a supply shock similar to that of the 1970s. Global commodity markets are very tight, but it may be that the primary driver of surging prices today comes from some other source.

Of course, there may be specific factors affecting the prices of individual commodities, such as the "peak oil hypothesis" or that corn prices have been impacted by U.S. subsidies for ethanol. But it must be more than a coincidence that commodity prices have risen virtually across the board. Some macroeconomic explanation must be involved.

The popular explanation since 2004 has been rapid growth in the world economy. Of course, the strongest growth has been coming from China and other rapidly growing Asian countries. But the expansion has been unusually broad-based -- including the United States until last year and even a reinvigorated Europe. So is higher growth the explanation for higher prices of farm products, energy and other industrial inputs?

This interpretation now looks suspect. Since last summer the U.S. economy has slowed down noticeably, and it is probably in a recession. And, despite strong growth prospects in countries like China and Russia, which are driven by domestic demand, the world economy is also slowing down. The International Monetary Fund's latest projections released this week show the overall global growth rate for 2008 has been marked down to 3.9 percent from 5.2 percent that was projected last summer, just before the subprime mortgage crisis hit.

If strong economic growth is not the explanation for the large increases since 2001 in the prices of virtually all mineral and agricultural commodities, then what is? The developments of the last six months have provided added support for a theory suggested by Jeffrey Frenkel of Harvard University -- that real interest rates are an important determinant of real commodity prices.

The idea is that high interest rates reduce the demand for storable commodities, or they increase the supply through a variety of channels:

• by increasing the incentive for extraction today rather than tomorrow;

• by decreasing firms' desire to carry inventories; and

• 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. This is exactly what 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 now.

As economic growth has slowed sharply, both in the United States and globally, the Federal Reserve has reduced interest rates. Firms and investors have responded by shifting into commodities. This is why commodity prices have resumed their upward march over the last six months, rather than falling, despite the poorer economic prospects.

Moreover, the phenomenal increase in the price of virtually every commodity in January and February cannot be due to demand because this was a period when the economic news was getting bleaker by the day. Nor are the recent commodity price increases attributable primarily to the falling value of the dollar. True, the dollar price of an internationally traded commodity should rise when the dollar falls. But the dollar only depreciated 7 percent against the euro between Jan. 1 and March 17, while the average commodity gained more than twice that amount.

On March 18, when the Federal Reserve reduced its lending rate by less than the market expected, there was an immediate correction in commodity markets. But the effect has not lasted long, and prices are again drifting upward.

For the Federal Reserve and other central banks, this should be a cause for concern. The current surge in commodity prices may reflect a reversion in investor thinking to conditions that existed more than 20 years ago. Confidence in central bank willingness to maintain a stable price level has eroded. Tangible assets are now more valued.

Disciplined central bank polices since 1980 had made the fear of inflation history. If investors perceive that this approach has now been abandoned, then the move from cash into commodities will continue.

This explanation, if correct, does not simplify the policy choices for Russia. At some point in the business cycle, interest rates will become positive again in real terms and commodity prices will decline. They could even overshoot to the extent that investors flocked into them. To avoid the fate of the African debtors, the best strategy for Russia is to consider the price spikes as temporary.

The problem, of course, is what happens if political exigencies in the United States and elsewhere continue to dictate a loose monetary policy to inflate all asset prices including housing. In that case, the calculation becomes definitively even more complicated.

Martin Gilman, a former senior representative of the IMF in Russia, is a professor at the Higher School of Economics in Moscow.