The Greenback and Commodity Prices

The original version of this report appeared in Wainwright Economics on September 11, 2008
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To address the problems associatedwith rising food prices, we mustunderstand what has caused pricesto rise. This report identifies a majorcause of the rise in food and othercommodity prices since 2001: a weakU.S. dollar.

The evidence suggests that theFederal Reserve is a major culprit inthe commodity inflation story. Butyou wouldn’t know it from reading thepress or listening to officialdom andthe political chattering classes. Thisisn’t surprising. After all, economichistory is written, to a large extent, bycentral bankers. In consequence, oneshould take official accounts with alarge dose of salt.

When charged with blowingbubbles, all Fed officials-from formerchairman Alan Greenspan to chairmanBen S. Bernanke-proclaim theirinnocence. Let's look at the evidence.

What is a bubble? A bubble is createdwhen the Fed's laxity allows aggregatedemand to grow too rapidly.Specifically, a demand bubble occurswhen nominal final sales to U.S. purchasers(GDP - exports + imports -change in inventories) exceeds a trendrate of nominal growth-a trend ratethat is consistent with "moderate" inflation-by a significant amount.

During Greenspan's 18-year tenureas Fed chairman, nominal finalsales grew at a 5.4% annual trendrate. This reflects a combination ofreal sales growth of 3% and inflationof 2.4% (Figure One). But there weredeviations from the trend.

The first deviation began shortlyafter Greenspan became chairman. Inresponse to the October 1987 stockmarket crash, the Fed turned on itsmoney pump and created a bubble:over the next year, final sales shot upat a 7.5% rate, well above the trendline. Having gone too far, the Fedthen lurched back in the other direction.The ensuing Fed tightening produceda mild recession in 1991.

From 1992 through 1997 growthin the nominal value of final sales wasquite stable. But successive collapsesof certain Asian currencies, the Russianruble, the Long Term CapitalManagement hedge fund and finallythe Brazilian real triggered anotherexcessive Fed liquidity injection. Thisresulted in a boom in nominal finalsales and a bubble in 1999-2000. Thiswas followed by another round of Fedtightening, which coincided with thebursting of the equity bubble in 2000and a slump in 2001.

Figure One
Final Sales to Domestic Purchasers (FSDP)
Final Sales to Domestic Purchasers (FSDP)

The last big jump in nominalfinal sales was set off by the Fed's liquidityinjection to fend off the falsedeflation scare in 2002. Fed GovernorBen S. Bernanke (now chairman) setoff a warning siren that deflation wasthreatening the U.S. economy whenhe delivered a dense and noteworthyspeech, "Deflation: Making Sure itDoesn't Happen Here," on November21, 2002.1 He convinced his Fed colleaguesthat the deflation danger waslurking. As Greenspan put it, "Weface new challenges in maintainingprice stability, specifically to preventinflation from falling too low."2 ByJuly 2003, the Fed funds rate was at arecord low of 1%, where it stayed for ayear. This produced the mother of allliquidity cycles and yet another massivedemand bubble.

During the Greenspan years, andcontrary to his claims, the Fed overreactedto real or perceived crises andcreated three demand bubbles. Thelast represents one bubble too many-and one that is impacting us today.

Not surprisingly, the mother ofall liquidity cycles was accompaniedby a weak dollar. Indeed, the FederalReserve's Trade Weighted ExchangeIndex fell by 26% from December 28,2001 to mid-July 2008. And as everycommodity trader knows, all commodities,to varying degrees, tradeoff changes in the value of the dollar.When the value of the dollar falls, thenominal dollar prices of internationallytraded commodities-like gold, rice,corn and oil-must increase becausemore dollars are required to purchasethe same quantity of any commodity.Accordingly, a weak dollar should signalhigher commodity prices. And ithas. Since 2001, when the dollar startedits downward slide, until mid-July2008, the fifty-five commodities thatmake up the Food and AgriculturalOrganization of the United Nation's"Food Price Index" have increased by127%.

To examine the link between thegreenback and commodity prices, acounterfactual-a what if, thought experiment-is well suited. Counterfactualsare often employed to examinealternatives to actual history. For example,what would have happened if,contrary to fact, some present conditionwere changed?

The use of counterfactuals hasa rich, if not controversial, history.Perhaps the most famous counterfactualwas employed by Professor RobertFogel of the University of Chicagoin Railroads and American EconomicGrowth.3 In that book, Professor Fogelcalculated what the transportationsystem of the United States in 1890would have looked like without railroads.His calculations created a greatcontroversy. But they were robust andhelped him win the 1993 Nobel Prizein Economics.

Table One
Counterfactual: The Contribution of the Weak Dollar to Commodity Price Increases
Counterfactual: The Contribution of the Weak Dollar to Commodity Price Increases

computation for the weak-dollar contribution to the price increase of rough rice

Table 1 contains the results ofcounterfactual calculations. By computingwhat the prices of various commoditieswould have been on July 11,2008, if the U.S. dollar-euro exchangerate would have remained the same asit was on December 28, 2001, we candetermine (on a counterfactual basis)what the exchange-rate (weak dollar)contribution to the total change invarious commodity prices has been inthe period under study. For example,rough rice prices have increased by385%, and the weak dollar has contributed55.53% to the price increaseof rough rice. In the case of roughrice, real factors (supply and demandfundamentals) have also contributedto the price increase in the period understudy-namely 44.47%. This is signifiedby a "+" sign in the last columnof Table 1 for rough rice.

Lean hogs are at the other endof the spectrum. If the dollar-euro exchangerate would have remained at itsDecember 28, 2001 level, the price oflean hogs would have declined from57.05 cent/lbs. to 41.74 cent/lbs. duringthe December 28, 2001-July 11,2008 period. In fact, the price of leanhogs was 74.65 cents/lbs. on July 11,2008. Accordingly, the exchange-ratecontribution to the change in the priceof lean hogs in the period under studywas 186.98%. This contribution exceeds100% because real factors wereworking to depress the price of leanhogs, and that is why a "-" sign is enteredin the last column for lean hogs.

Table Two
Changes in the Value of the Dollar and Commodity Prices
Changes in the Value of the Dollar and Commodity Prices

Given the dollar's recent upsurgein value, we don't have to rely solely ona counterfactual thought experimentto show how nonsensical "Fedspeak"can be. As Table 2 indicates, the dollar has appreciatedagainst the euro by 6.9% duringthe July 11-August 11, 2008 period.With the exception of live cattle andlean hogs, the prices of all commoditieslisted have fallen. And the CRBFoodstuffs and Spot Indexes havefallen by -7.12% and -6.31%, respectively,during the period in question.That's almost a perfect mirror imageof the dollar's strength.

Contrary to Fed chairman Bernanke'sSemiannual Monetary PolicyReport to the Congress, which hedelivered on July 15, 2008,4 the weakdollar has played a significant role inpushing up food and commodity prices.If the dollar continues to strengthen,it will provide relief from sky-highfood and commodity prices.

In closing, let us address the priceof crude oil-an important input inthe production and distribution offood. In the December 28, 2001-July11, 2008 period, the weak dollar contributedalmost $64 per barrel to thetotal rise in the price of oil. A strongerdollar would put considerable downwardpressure on crude oil prices.In addition, the U.S. government'sStrategic Petroleum Reserve could betransformed from a "dead" resourceinto a dynamic, market-based force.This, too, would put downward pressureon crude prices.

The SPR is a response to the oilembargo imposed by the Organizationof Arab Petroleum Exporting Countriesafter the 1973 Arab-Israeli War. Itcomprises five underground storage facilities,hollowed out from salt domes,located in Texas and Louisiana. By2005, the SPR's capacity reached itscurrent level of 727 million barrels.At present, 706.8 million barrels arestored in the SPR. That's over twicethe size of private crude oil inventories.To put SPR's size into perspective,its current storage would cover about71 days of U.S. crude oil imports or 47days of total U.S. crude oil consumption.

The SPR's drawdown capacity is4.3 million barrels per day. That rateis slightly greater than the combineddaily crude oil exports from Iran andKuwait. In short, the SPR is huge.

Not being faced with capital carryingcharges and never wanting tobe caught short, government officials,like proud pack rats, want to just sit onthis mother of all commodity hoards.They argue that the SPR represents aninsurance policy for national emergencies.But without a specified releaserule, just what is the insurance policywritten for?

What should be done with thehoard of crude oil in the SPR? It'stime to remove the SPR's "fill" and"release" rules from the grip of politics.Market-based release rules wouldtransform the SPR into an oil bank.It would provide the country with ahuge precautionary inventory of oil,generate revenue to defray some ofthe government's stockpiling costs,smooth out crude oil price fluctuations,and push down spot pricesrelative to prices for oil to be deliveredin the future. It would also force thegovernment to "buy-low" (when crudeoil is plentiful) and "sell-high" (whencrude is scarce).

How would the oil bank work?To implement a "sell-high" releaserule, the government should sell outof the money covered call options onthe SPR stockpile. It might, say, sellDecember 2008 call options with astrike price of $150 a barrel. If theprice surged above that level, the optionbuyer would exercise the optionand take delivery of crude oil fromthe government's stockpile. If theprice never reached $150, the optionwould expire worthless and no crudeoil would be released.

To implement a "buy-low" fillrule, the government should sell outof the money put options.5 It might,say, sell December 2008 put optionsat $70 a barrel. If the price fell below$70, the option buyer would exercisethe option and sell crude to the governmentfor delivery to the SPR.

If we want lower oil prices, we canobtain them immediately by replacingpolitically-based fill and release rulesfor the SPR with market-based rules.


  1. Ben S. Bernanke, "Deflation: Making Sure "It" Doesn’t Happen Here", Remarks by Governor Ben S. Bernanke Before the National Economists Club,Washington, D.C., November 21, 2002.
  2. Alan Greenspan, Federal Reserve Board’s semiannual monetary policy report to the Congress, Testimony of Chairman Alan Greenspan before the Committeeon Financial Services, U.S. House of Representatives, Washington, D.C., July 15, 2003.
  3. Robert W. Fogel, Railroads and American economic growth: essays in econometric history, Baltimore: The Johns Hopkins Press, 1970.
  4. Ben S. Bernanke, Semiannual Monetary Policy Report to the Congress, Testimony of Chairman Ben S. Bernanke before the Committee on Banking,Housing, and Urban Affairs, U.S. Senate, July 15, 2008.
  5. I thank Prof. Ronald McKinnon of Stanford University for prompting me to include a fill rule.

Steve H. Hanke

Steve H. Hanke is a Professor of Applied Economics at The Johns Hopkins University in Baltimore and a Senior Fellow at the Cato Institute.