Plain Sense Economics

Harvard University’s Martin Feldstein wrote in the Wall Street Journal today (April 15, 2008 – see article) that the Federal Reserve should stop lowering interest rates. He argues that lower interest rates have a special impact on commodity (i.e. food, oil) prices.

But high unemployment and low capacity utilization would not prevent lower interest rates from driving up commodity prices. Many factors have contributed to the recent rise in the prices of oil and food, especially the increased demand from China, India and other rapidly growing countries. Lower interest rates also add to the upward pressure on these commodity prices – by making it less costly for commodity investors and commodity speculators to hold larger inventories of oil and food grains.

What he is pointing out here is a reminder that our global, electronic system for investments has led to investors buying and selling commodities, like oil and wheat. It is not simply that wheat is grown and sold somewhere to be processed and consumed. Instead, investment organizations buy contracts for the future delivery of these commodities and then hold onto, or sell, or leverage these contracts in order to make money. To do this kind of investment requires credit. Lower interest rates means cheaper credit. And this in turn makes it easier for these investors to hold onto these contracts, waiting for prices to rise further. It becomes self-fulfilling, and meanwhile the commodities don’t get delivered to those who need them.

Feldstein further argues that high commodity prices have a particularly chilling effect on the economy of developing nations, where a high percentage of consumption (and thus GDP) is linked to purchases of these goods. He suggests that those governments then must subsidize purchases or support lower prices, which drains government resources away from longer term, beneficial investments.

We need to keep watching the issue of rising food prices. There are already news reports of riots and political instability driven by rising food costs. Feldstein’s further caution about the opportunity cost of paying for food is important.