Commodity prices to stay high

Friday, June 27

Commodity prices are increasing faster than at any point in at least a generation.  There is strong consensus that prices will continue to be highly volatile and also remain at historically high levels through at least the remainder of 2008.

There are a multitude of possible explanations for the surging prices:

• Supply and demand. The global economy has experienced strong growth, lifting hundreds of millions of people out of poverty, and made middle-class consumers out of hundreds of millions more in countries like China, India and Brazil. In addition, drought has devastated agricultural production in various parts of the world and, in light of the shortages, many countries are adopting policies to reduce supply to world markets

• A weak dollar. Even after falling for five consecutive years, the dollar has still managed to fall over 13% relative to the yen and euro over the past twelve months. This has driven up the price to US buyers but also enriched investors holding foreign currencies, facilitating the purchase of commodities traded in New York.

• Questionable policies. US ethanol policy is a particularly egregious example. The United States subsidises ethanol production via corn, a particularly inefficient source of ethanol. Today, US ethanol production consumes 25% of the US corn crop and within ten years the stated US ethanol production target would take the entire US corn crop, or 40% of world's corn supply.

• Speculators. With the downturn in housing markets and lagging stock markets, many pension funds have turned to commodities. The Commodity Futures Trading Commission (CFTC) is downplaying this explanation and has said there is no single speculative group responsible for affecting prices.

• Monetary policy. Low interest rates make holding commodity inventories cheap, according to Harvard economist Jeffrey Frankel. The lower cost of carrying physical inventories increases the attractiveness of speculating in commodities relative to holding Treasury bills.

However, while it is easy to point the finger at speculators, to date there is little hard evidence that speculators are driving markets to unsustainable levels. It appears much more likely that a prolonged bout of higher prices is in store. While oil and coal prices may fall from their current levels, there is little prospect that commodities will experience meaningful price falls in the near term.