London, 11 April 2011: Reuters

Announcing the first interest rate increase for almost three years on Thursday, ECB President Jean-Claude Trichet observed that "ample liquidity at global level" as well as strong demand from emerging markets was driving commodity prices higher. Trichet's carefully calculated remarks blew wide open disagreements among the main central banks about what role (if any) monetary policy has played in the surging cost of oil and a broad range of other industrial raw materials and agricultural products.

By drawing a link between commodity prices and central bank policy, Trichet endorsed work by the ECB's research economists highlighting monetary factors as one of the key drivers of commodity prices alongside global industrial production.

In a working paper published in 2009, the ECB's Isabel Vansteenkiste found strong statistical evidence a "common factor" explained the common upswing in non-fuel commodity prices. She linked it to financial variables such as real interest rates and the dollar's effective exchange rate as well as oil and other input costs and global industrial production ("How important are common factors in driving non-fuel commodity prices?").

Vansteenkiste's conclusions were validated by Serhan Cevik and Tahsin Saadi Sedik, researchers at the IMF, who noted co-movements in oil and fine wine prices and found "global liquidity conditions influence the dynamics of crude oil and fine wine prices".

While aggregate demand growth, especially in emerging markets, was the most decisive factor determining crude and wine prices, global excess liquidity "seems to have some role" according to the authors ("A barrel of oil or a bottle of wine: how do global growth dynamics affect commodity prices?").

Researchers at the Bank of Japan agree. In a paper published in the Bank of Japan Review, they conclude "it is safe to say that globally accommodative monetary conditions are a key driver of the rise in commodity prices by stimulating both physical demand for commodities and investment flows into commodity markets".

"Equally the financialisation of commodities, as demonstrated by the rapid increase in commodity futures investments by financial investors, has amplified the fluctuation of fundamental factors, thereby amplifying the price fluctuations" according to the authors ("Recent surge in global commodity prices").

They note commodities have a dual aspect as a consumption good and financial asset. The historical relation between commodity prices and the global output gap has broken down recently as prices have soared much more than the global gap implied. Financialisation has heightened the impact of even small changes in supply-demand factors.

SOMEONE IS WRONG

While the ECB, Bank of Japan and even the IMF acknowledge some monetary or liquidity influences on oil and other raw materials' prices, the Federal Reserve and the Bank of England continue to resist any link. Federal Reserve Chairman Ben Bernanke describes rising commodity prices as "transitory" and expects them to stabilise. Bernanke and the Federal Open Market Committee have laid blame for price rises on microeconomic supply and demand factors, especially strongly growing demand in emerging markets, and do not acknowledge that U.S. monetary policy might be a cause.

In a study published on its website, the Federal Reserve Bank of San Francisco found no evidence the Fed's two large-scale asset purchase (LSAP) programmes, more commonly known as quantitative easing, had fuelled the rise in commodity prices ("Are Large-Scale Asset Purchases Fueling the Rise in Commodity Prices?").

The San Francisco Fed conducted an event study and found "despite the fall in long-term interest rates and the depreciation of the dollar, commodity prices fell on average on days of LSAP announcements". The authors speculate prices fell because LSAP announcements heightened perceptions about the risks to the economic outlook.

There are limitations to the study. It looked at just 11 announcements linked to QE and analysis was restricted to commodity price movements during a 24-hour interval around the announcement. The authors found a big negative effect between announcements and commodity prices during the first round (QE1) in 2008-2009 (when the world financial system was collapsing) but a marginal one during the second round (QE2) in 2010 (when the Fed was instead trying to accelerate the recovery). Context is clearly crucial when examining the impact of liquidity provision on the price of oil and other assets.

In a previous publication, the San Francisco Fed argued "commodity prices track world demand" especially as measured by global industrial production, also downplaying the role of monetary and liquidity factors.

EXTERNALITIES

I have argued before that commodity prices would become a central consideration in monetary policy as commodity markets replace labour markets as the economy's key bottleneck, and central banks have to consider international interactions and spillovers in a globalised world economy.

But there is still no consensus among policymakers on the links between interest rates, liquidity, growth and commodity prices. Rising commodity prices are treated as exogenous supply-side and emerging-market demand shocks by the Federal Reserve and the Bank of England. But the ECB clearly considers them at least semi-endogenous.

Researchers at the Bank of Japan put it perfectly: "For individual central banks, the fluctuation in global commodity prices may be an exogenous supply shock. Even if a single central bank attempts to counter the fluctuation in commodity markets it may achieve nothing other than making the domestic economy more unstable".

"For each central bank, an independent action to tame global commodity markets may not be an optimal choice. The reluctance of each central bank to counter rising commodity prices, however, could make them all to be collectively worse off ... The failure of this collective action leads to a higher than expected increase in demand for commodities".

"This vicious cycle may develop self-fulfilling expectations of a further appreciation in commodity prices, thereby driving commodity prices above the equilibrium level justified by supply-demand conditions (as proxied by the global output gap."

"Eventually this process may increase the probability of the economy becoming trapped in a bubble." Indeed. If central banks cannot agree on their own role in commodity price movements there is little hope for a coordinated response capable of stabilising global inflation.

Ends --

The views expressed here are his own.