Although growth of the Asian manufacturing economies of India and China has slowed in response to slowing global markets and the recent credit crash, commodity prices remain high. Economist Jeffrey Frankel believes that that low real interest rates have been the cause as the continued strength of commodity prices:
One wouldn’t want to try to reduce commodity markets to a single factor, nor to claim proof of any theory by a single data point. Nevertheless, the developments of the last six months provided added support for a theory I have long favoured: real interest rates are an important determinant of real commodity prices.
- High interest rates reduce the demand for storable commodities, or increase the supply, through a variety of channels:
- by increasing the incentive for extraction today rather than tomorrow (think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled)
- by decreasing firms’ desire to carry inventories (think of oil inventories held in tanks), 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, as happened when real interest rates were 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 again during 2001-2004. It’s the original “carry trade.” (http://www.voxeu.org/index.php?q=node/1002)