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Responding to higher commodity prices

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28 June 2011 14:49

World commodity prices have risen for much of the past decade, with only a brief respite during the Global Financial Crisis. As a result, headline rates of inflation just about everywhere are well above normal.

Central banks are reluctant to respond with higher interest rates. Action by any individual country is not going to have much effect on world commodity prices and would be unhelpful to domestic demand: most developed countries have barely regained their pre-GFC GDP levels. There have been, however, two unconnected responses to these higher commodity prices.

First, the International Energy Agency has agreed to release 60 million barrels of oil from strategic stockpiles held by its members. This will be sold over the next 30 days, and does a bit more than make up for the loss of Libya's oil supply. The immediate response was a sharp fall in world oil prices.

Coming as it did after the failure of the OPEC countries to agree on increased quotas on 8 June, this might seem to be a powerful and positive move in a world of unstable commodity prices ('If OPEC cannot put a ceiling on the oil price, we will do it').

But the announcement was surprising. Saudi Arabia had offered to make up for the OPEC non-agreement, and Libya accounts only a couple of percent of world production. In any case, the release is fairly small (Washington is providing half the release, amounting to only 4% of its strategic stockpile). Still, IEA countries can't go on releasing oil every time the price rises — when they come to replenish their stockpiles, this will put upward pressure on market prices.

The second unusual event was the announcement by the World Bank that it would underwrite food-price hedging by developing countries. The Bank will provide $200 million of credit exposure which, in partnership with JPMorgan, might make possible $4 billion of hedging.

Hedging in commodity markets has a long and respectable history. It makes sense for both producers and consumers to reduce their risks through forward markets. That said, it remains unclear whether this sort of action stabilises or destabilises prices. If a country takes out insurance against a price increase, the insurer may well lay off its exposure through market purchases or bid up prices in futures markets.

But food price increases and instability are clearly a vexed issue for developing countries. Until a decade ago, world food prices lagged behind other price rises, but they have risen substantially faster over the past ten years. Consumers in these countries spend one-third of their income on food, and for the poor the proportion is higher still.

World Bank President Zoellick described these food price increases as a 'toxic brew of real pain causing social unrest'. He said this hedging initiative showed what 'sensible financial engineering could do: make lives better for the poor'. Some might have doubts, recalling what financial engineering did for investors during the Global Financial Crisis. Others will remember the failures of many past attempts to smooth commodity prices through stabilisation funds.

Zoellick also called for removal of regulations inhibiting greater production, quoting the case of the Tunisian fruit seller whose complaints about regulation had sparked the riots there. He might, as well, have identified issues closer to home: US subsidies and mandated blending rules aimed at encouraging biofuel production have resulted in 40% of the US corn crop being used for biofuels rather than as food. 

The price rises of both food and petroleum reflect underlying demand/supply relationships. Now that China, India, Brazil and a host of other emerging countries are growing quickly, world demand for commodities is strong. Supply is inelastic and so is demand. Measures such as the two described here might help to smooth out short-term price spikes and perhaps counter speculative buying. But they can't do much about the underlying fundamentals driving commodity prices up.

Photo by Flickr user silverfuture.