It's been a while since we talked about oil, but with prices back up the debates must begin anew. The aforementioned James Hamilton links to some interesting stuff from Jeffrey Frankel, an economist at Harvard University. Frankel explores the link between interest rates and commodity prices, and notes an inverse effect. Here's his explanation:
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, 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 commodity contracts (spot and forward), and into treasury bills.
All three mechanisms work to reduce the market price of commodities, as happened when real interest rates where 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 during 2001-2004. As the Fed funds rate goes back up over the coming year, one can expect commodity prices eventually to come back down. Call it part of the unwinding of the "carry trade."
You can read a fuller analysis on his website, as well as responses to some objections.
The chart on the right plots commodity prices against real interest rates between 1950-2003. Although there is some correlations, it's clearly not tight. If the theory is true, or does hold some water, it speaks to one of the few truisms of economics--price controls don't work; even when it comes to the price of money. Try to hold money artificially cheap, to spur expansion or provide liquidity or whatnot, and the price of raw materials will rise to balance it out.
As elegant as his explanation is, it doesn't fully satisfy the China and India are the cause of everything-crowd. Their rapidly growing thirst for oil, and the dwindling supply of the easy sweet stuff seems to be a real phenomenon. It'll be interesting to see what happens over the next few months as we near a peak of the rate increases.