Rising US real interest rates imply falling real commodity prices

First posted on: 

Jeffrey Frankel's Blog, 25 August 2018

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 real commodity prices are headed down.

The theory of the relationship between real interest rates and commodity prices is long established.  I like the ‘overshooting’ formulation of the theory.  The econometric relationship is also pretty well established, by statistical analyses that range from: 

• simple correlations; to
• regressions that control for other important determinants such as GDP and inventories in a ‘carry trade’ model; to 
• 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 incentives to extract today, rather than leaving deposits in the ground for tomorrow.   Second, for commodities that have been ‘financialised’, 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 at two venues: 

• the National Minerals Information Center Seminar Series of the U.S. Geological Survey, in Reston VA on 23 August (click here for my pptslides, or PDF); and
• the 2nd annual symposium of the JPM Center for Commoditiesat the University of Colorado on 15 August (my ppt or PDF).  My keynote at the latter received some coverage in the Chinese press.

What does all this 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 normalisation 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.