The Dismal Science: Mr. Greenspan's Strategic Reserve
There is little doubt that the Federal Reserve is about to pump up the federal-funds rate by 25 basis points to 1.75% as part of Alan Greenspan's kabuki dance to control inflation. It is also a textbook response to oil prices that are now about 35% more expensive than they were at the beginning of the year. But the truly deft and sneaky aspect of the increase is that higher oil prices themselves are probably a result of Mr. Greenspan's really loose monetary policy.</br></br>This explanation of the current situation is in fact a mirror image of the one identified by Jeffrey A. Frankel, economist at Harvard's Kennedy School of Government, in the 1980s. ("Expectations and Commodity Price Dynamics: The Overshooting Model," available online.) Back then, real interest rates were high and prices for commodities, including oil, were in a swoon.</br></br>Mr. Frankel's argument was simple and elegant. Changes in the money supply resulted in changes in real interest rates and the first impact of these changes was seen in prices for commodities. Thus, as real rates went up, commodity prices went down. Consider, then, Mr. Frankel's model applied to what has been happening more recently.</br></br>As Mr. Greenspan engineered low real interest rates in 2001-04, the prices of commodities, particularly oil and other minerals, started to climb in advance of a general price increase. Why? The prices of some things, like manufactured goods, are sticky. They don't change very fast because they may be fixed by explicit contracts, there may be imperfect information, or businesspeople may want to postpone the costs attached to changing their prices. Commodity prices, on the other hand, are way more flexible. Since commodity prices are determined by trading on fast-moving auction markets, they respond more swiftly to interest-rate expectations and monetary fluctuations than do consumer prices.</br></br>But, in the short run, these faster-adjusting markets overshoot their long-run equilibrium prices. Since some prices are sticky -- or lag behind -- the prices that are free to move, like commodity prices, must move in an exaggerated fashion in order to compensate for the laggards. Thus, commodity prices overshoot their new equilibrium in order to generate an expectation of future depreciation that is sufficient to offset lower interest rates. This skyrocket effect will vanish in the long run.