Mr. Chairman and members of the House Committee on the Budget,thank you for this opportunity to present my views on rising foodprices. To address the problems associated with rising food prices,we must understand what has caused prices to rise. I will address amajor cause of the rise in food and other commodity prices since2001.
The evidence suggests that the Federal Reserve is a majorculprit in the commodity inflation story. But you wouldn't know itfrom reading the press or listening to officialdom and thepolitical chattering classes. This isn't surprising. After all,economic history is written, to a large extent, by central bankers.In consequence, one should take official accounts with a large doseof salt.
Just consider the "bubble-blowing" charges leveled at the formerchairman of the Federal Reserve System Alan Greenspan. The formerchairman has proclaimed his innocence. Let's look at theevidence.
What is a bubble? A bubble is created when the Fed's laxityallows aggregate demand to grow too rapidly. Specifically, a demandbubble occurs when nominal final sales to U.S. purchasers (GDP -exports + imports - change in inventories) exceeds a trend rate ofnominal growth - a trend rate that is consistent with "moderate"inflation - by a significant amount.
During Greenspan's 18-year tenure as Fed chairman, nominal finalsales grew at a 5.4% annual trend rate. This reflects a combinationof real sales growth of 3% and inflation of 2.4% (see Chart 1). Butthere were deviations from the trend.
Chart 1. Final Sales to Domestic Purchasers(FSDP) from 1987Q1 to 2008Q1 (year/year)
The first deviation began shortly after Greenspan becamechairman. In response to the October 1987 stock market crash, theFed turned on its money pump and created a bubble: over the nextyear final sales shot up at a 7.5% rate, well above the trend line.Having gone too far, the Fed then lurched back in the otherdirection. The ensuing Fed tightening produced a mild recession in1991.
From 1992 through 1997 growth in the nominal value of finalsales was quite stable. But successive collapses of certain Asiancurrencies, the Russian ruble, the Long Term Capital Managementhedge fund and finally the Brazilian real triggered anotherexcessive Fed liquidity injection. This resulted in a boom innominal final sales and a bubble in 1999-2000. This was followed byanother round of Fed tightening, which coincided with the burstingof the equity bubble in 2000 and a slump in 2001.
The last big jump in nominal final sales was set off by theFed's liquidity injection to fend off the false deflation scare in2002. Fed Governor Ben S. Bernanke (now chairman) set off a warningsiren that deflation was threatening the U.S. economy when hedelivered a dense and noteworthy speech, "Deflation: Making Sure itDoesn't Happen Here," on November 21, 2002. He convinced his Fedcolleagues that the deflation danger was lurking. As Greenspan putit, "We face new challenges in maintaining price stability,specifically to prevent inflation from falling too low."(Congressional testimony delivered on July 15 and 16, 2003). ByJuly 2003, the Fed funds rate was at a record low of 1%, where itstayed for a year. This produced the mother of all liquidity cyclesand yet another massive demand bubble.
During the Greenspan years, and contrary to his claims, the Fedoverreacted to real or perceived crises and created three demandbubbles. The last represents one bubble too many--and one that isimpacting us today.
Not surprisingly, the mother of all liquidity cycles has beenaccompanied by a weak dollar. Indeed, the Federal Reserve's TradeWeighted Exchange Index has fallen by 24% since 2001. And as everycommodity trader knows, all commodities, to varying degrees, tradeoff changes in the value of the dollar. When the value of thedollar falls, the nominal dollar prices of internationally tradedcommodities--like gold, rice, corn and oil--must increase becausemore dollars are required to purchase the same quantity of anycommodity. Accordingly, a weak dollar should signal highercommodity prices. And it has. Since 2001, when the dollar startedits downward slide, the fifty-five commodities that make up theFood and Agricultural Organization of the United Nation's "FoodPrice Index" have increased by 127%.
To examine the link between the greenback and commodity prices,a counterfactual - a what if, thought experiment - is well suited.Counterfactuals are often employed to examine alternatives toactual history. For example, what would have happened if, contraryto fact, some present condition were changed?
The use of counterfactuals has a rich, if not controversial,history. Perhaps the most famous counterfactual was employed byProfessor Robert Fogel of the University of Chicago inRailroads and American Economic Growth. In that book,Professor Fogel calculated what the transportation system of theUnited States in 1890 would have looked like without railroads. Hiscalculations created a great controversy. But they were robust andhelped him win the 1993 Nobel Prize in Economics.
Table 1 contains the results of counterfactual calculations. Bycomputing what the prices of various commodities would have been on11 July 2008, if the U.S. dollar-euro exchange rate would haveremained the same as it was on 28 December 2001, we can determine(on a counterfactual basis) what the exchange-rate (weak dollar)contribution to the total change in various commodity prices hasbeen since 2001. For example, rough rice prices have increased by385% since 2001, and the weak dollar has contributed 55.53% to theprice increase of rough rice. In the case of rough rice, realfactors (supply and demand fundamentals) have also contributed tothe price increase since 2001--namely 44.47%. This is signified bya "+" sign in the last column of Table 1 for rough rice.
Lean hogs are at the other end of the spectrum. If thedollar-euro exchange rate would have remained at its 28 December2001 level, the price of lean hogs would have declined from 57.05cent/lbs. to 41.74 cent/lbs. during the 28 December 2001 - 11 July2008 period. In fact, the price of lean hogs was 74.65 cents/lbs.on 11 July 2008. Accordingly, the exchange-rate contribution to thechange in the price of lean hogs since 2001 was 186.98%. Thiscontribution exceeds 100% because real factors were working todepress the price of lean hogs, and that is why a "-" sign isentered in the last column for lean hogs.
Counterfactual: The Contribution of the Weak Dollar to CommodityPrice Increases (28-Dec-2001 to 11-Jul-2008)
Given the dollar recent upward surge in value, we don't have torely solely on a counterfactual thought experiment to show hownonsensical "Fedspeak" can be. As Table 2 indicates, the dollar hasappreciated against the euro by 6.9% during the 11 July - 11 August2008 period. With the exception of live cattle and lean hogs, theprices of all commodities listed have fallen. And the CRBFoodstuffs and Spot indexes have fallen by -7.12% and -6.31%,respectively, during the period in question. That's almost aperfect mirror image of the dollar's strength.
Changes in the Value of the Dollar and Commodity Prices(11-Jul-2008 to 11-Aug-2008)
Contrary to Fed chairman Bernanke's Semiannual Monetary PolicyReport to the Congress, which he delivered on July 15, 2008, theweak dollar has played a significant role in pushing up food andcommodity prices. A stronger dollar would provide relief fromsky-high food and commodity prices.
In closing, I would like to address the price of crude oil--animportant input in the production and distribution of food. Since2001, the weak dollar has contributed almost $64 per barrel to thecurrent price of oil. In addition to a stronger dollar, the U.S.government's Strategic Petroleum Reserve could be transformed froma "dead" resource into a dynamic, market-based force that would putconsiderable downward pressure on crude oil prices.
The SPR is a response to the oil embargo imposed by theOrganization of Arab Petroleum Exporting Countries after the 1973Arab-Israeli War. It comprises five underground storage facilities,hollowed out from salt domes, located in Texas and Louisiana. By2005, the SPR's capacity reached its current level of 727 millionbarrels. At present, 706.8 million barrels are stored in the SPR.That's over twice the size of private crude oil inventories. To putSPR's size into perspective, its current storage would cover about71 days of U.S. crude oil imports or 47 days of total U.S. crudeoil consumption. The SPR's drawdown capacity is 4.3 million barrelsper day. That rate is slightly greater than the combined dailycrude oil exports from Iran and Kuwait. In short, the SPR ishuge.
Not being faced with capital carrying charges and never wantingto be caught short, government officials, like proud pack rats,want to just sit on this mother of all commodity hoards. They arguethat the SPR represents an insurance policy for nationalemergencies. But without a specified release rule, just what is theinsurance policy written for?
What should be done with the hoard of crude oil in the SPR? It'stime to remove the release rules from the grip of politics.Market-based release rules would transform the SPR into an oilbank. It would provide the country with a huge precautionaryinventory of oil, generate revenue to defray some of thegovernment's stockpiling costs, smooth out crude oil pricefluctuations, and push down spot prices relative to prices for oilto be delivered in the future.
How would the oil bank work? The government would sell out ofthe money covered call options on the SPR stockpile. It might, say,sell December 2008 call options with a strike price of $150 abarrel. If the price surged above that level, the option buyerwould exercise and take delivery of crude oil from the government'sstockpile. If the price never reached $150, the option would expireworthless and no crude oil would be released.
If we want lower oil prices, we can obtain them immediately byreplacing politically-based release rules for the SPR withmarket-based rules.