In his Saturday column in the Business Standard, T.N. Ninan wrote on the recent rout in commodities in the context of the surprise 50 basis points rate hike by the Reserve Bank of India (RBI) last week. The subtext was that RBI might have tightened too much too late. That conclusion is premature. To be sure, the rout in all commodities—starting with silver—was big and it is welcome to India. Unfortunately, however, the decline does not herald the end of the bull market in commodities.
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The surge in commodities started with the announcement of the purchase of treasury securities by the Federal Reserve Board last August. Monetary policy, via low interest rates and liquidity, plays an important role in creating and sustaining speculative (as opposed to commercial) demand for commodities. Low interest rates mean the cost of borrowing to speculate on financial contracts is negligible. Further, low interest rates encourage banks to provide more debt financing to their favourite clients (institutional and individual) and to allot more money to their own proprietary trading units to take large bets.
Apart from this, the Federal Reserve also encourages speculative behaviour with its light-touch regulation of financial institutions. As recently as last week, Ben Bernanke expressed fears that regulators might stifle reasonable risk-taking and innovation in financial markets as they play a role in broader productivity gains, economic growth and job creation (www.bloomberg.com/news/2011-05-05/bernanke-says-regulators-must-avoid-rules-that-are-burdensome-to-banks.html). As far as your columnist can recall, no responsible policymaker or academic has found financial innovations guilty of the “crimes” that Bernanke charges them with.
In contrast and thankfully, the Bank of Japan (BoJ) review paper published in March 2011 (“recent surge in commodities prices—impact of financialisation of commodities and globally accommodative monetary conditions”) produces convincing arguments that nail the role of central banks in fostering speculative demand for commodities.
They first provide visual evidence of the positive correlation between global output gaps (actual growth rate minus potential growth rate) and commodity prices. Then, they demonstrate the pronounced upward shift in commodity prices in the period since 2006 over and above that could be explained by output gaps. This excess upward shift in commodity prices is then explained by interest rate gap. Interest rate gap is the difference between real short-term interest rate and the potential growth rate of an economy. Real short-term interest rate, in turn, is defined as the difference between the nominal short-term interest rate minus headline consumer price index inflation. In the developed world, the interest rate gap turned negative in 2006 and remains so. Interest rate gap in emerging economies has been negative throughout the last decade. In plain English, real interest rates have been too low to foster real savings and investment.
Then, they show the correlation between commodity prices and the measures of interest rate gaps to be negative. If commodity prices respond to output gaps closing (that is, actual GDP growth rising above potential growth), then inflation pressures would intensify and central banks would raise interest rates. This would have the effect of turning interest rate gaps positive. The correlation between commodity prices and interest rate gaps would be positive.
The observed negative correlation shows that central banks do not perceive the increases in commodity prices to be inflationary and, hence, they do not respond. Consequently, both inflation expectations and actual inflation rise due to the rise in commodity prices. The interest rate gap remains negative or becomes more so. In turn, that fuels more speculation in commodity prices as the negative rate gap induces yield-seeking investments into financial markets.
The authors of the BoJ review were polite and held all central banks responsible for the situation. Not all central banks print reserve currencies. Only the US has that privilege. Plainly stated, the US is responsible for this state of affairs.
What is the chance that the Federal Reserve would act to close the interest rate gap in the US, thus allowing other central banks to do so? Close to zero, as the Federal Reserve is keen to hold interest rates exceptionally low for an extended period. Evidence to back the role of exceptionally low interest rates in fostering economic recovery is scant, if it exists at all. Low interest rates discourage saving and hence cannot encourage investment. Nor can cheap credit be the cure to problems brought about by cheap credit. But these fall on deaf ears and are falsely premised on public policy batting for public interest.
The only way this would end is when the US is confronted by a “popular nonlinear response to the linearly increasing concentration of economic power that isn’t devoted to popular improvement” (www.wilmott.com/blogs/eman/index.cfm/2011/4/24/Capitalist-Nonlinearities). Since non-linearity is inherently unpredictable, the short answer to the question of whether the task of RBI is done is a resounding no.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views.
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