Comment: Real rates key to commodities prices

(Jeffrey Frankel is James W. Harpel professor of capital formation and growth at Harvard Kennedy School, a former member of the White House council of economic advisors and a guest columnist on reuters.com. The opinions expressed are his own.)

By Professor Jeffrey Frankel

BOSTON (Reuters.com) -- It is hard to remember now, but mineral and agricultural commodities were considered passé less than 10 years ago. Anyone who talked about sectors where the product was as clunky and mundane as copper, corn, and crude petroleum, was considered behind the times. In Alan Greenspan's phrase, GDP had gotten "lighter;" the economy was becoming weightless, "dematerializing." Agriculture and mining no longer constituted a large share of the New Economy, and did not matter much in an age dominated by ethereal digital communication, evanescent dotcoms, and externally outsourced services. The Economist magazine in a 1999 cover story forecast that oil might be headed for a price of $5 a barrel.

Since then, of course, we have seen tremendous increases in the prices of most mineral and agricultural commodities, many of them hitting records in nominal and even real terms. Oil is now well above $100 a barrel, and gold has just crossed the $1,000 an ounce line.

The question is why.

There could well be merit to many of the explanations that have been offered for the rise in the price of oil. One is the "peak oil hypothesis," and another is geopolitical uncertainty in Russia, Nigeria, Venezuela and -- above all -- the Gulf. Corn prices have been impacted by American subsidies for biofuel. And other special microeconomic factors are relevant in other specific sectors. But it cannot be a coincidence that mineral and agricultural prices have risen virtually across the board. Some macroeconomic explanation is called for.

The popular explanation since 2003 has been rapid growth in the world economy. The strongest growth has, of course, been coming from China and other recently minted manufacturing powerhouses in Asia, but the expansion has been unusually broad-based -- including up to last year the United States and even a reinvigorated Europe. So growth has pushed up demand for energy, minerals, farm products, and other industrial inputs, right?

This reigning explanation now looks suspect. Since last summer the U.S. economy has slowed down noticeably, and is probably entering a recession. Despite talk of decoupling, it is clear that other countries are also slowing down at least to some extent. In its most recent forecast, the IMF World Economic Outlook revised downward the growth rate for virtually every region, including China. The overall global growth rate for 2008 has been marked down by 1.1 percent (from 5.2 percent in July 2007, just before the subprime mortgage crisis hit, to 4.1 percent as of January 29, 2008). And prospects continue to deteriorate. Yet commodity prices have found their second wind over precisely this period. Up some 25 percent or more since August 2007, by a number of indices. So much for the growth explanation.

How to explain commodity prices up while the economy turns down? If strong economic growth is not the explanation for the large increases since 2001 in prices of virtually commodities, then what is?