Quantitative Easing and Commodity Prices: An MMT Approach

By Payam Sharifi
The author is currently pursuing his Ph.D. in Economics and Public Administration at the University of Missouri – Kansas City

One of the most common observations I make as I frequent the comments section of MMT blogs are the arguments in objection to it.  When one mentions “keystrokes”, these posters immediately think of Weimar Germany and machines printing money and throwing them out into the streets (via helicopter or otherwise).  After these commentators understand (through the help of other posters) that MMT notes that inflation is the only possible constraint to the issuer of a sovereign currency, they typically have their “gotcha” moment.  Quantitative Easing (QE), they note, has been responsible for higher commodity prices and hence, MMT’ers are a bunch of crazy fanatics who want to turn the nation and the world into Weimar (or Zimbabwe).  The even larger implication is that enacting goals for the public purpose is not something the government should be involved with.  The view that QE is responsible for higher commodity prices is not entirely without merit, but not for reasons typically ascribed to it.  By understanding the institutional aspects that MMT describes, one will understand not only the real transmission mechanism but also some other problems and solutions associated with higher energy prices.  This post makes an outline of these issues.

Quantitative easing is essentially an asset swap between the Federal Reserve and its member banks.  The idea behind QE is to bring down the long end of the yield curve (that is, to bring down long term interest rates) that cannot be targeted in the traditional way through a zero interest rate policy (ZIRP) alone.  This in turn can help spur lending, in addition to inducing market participants to invest in industrial capital or equities.  All of the “money printing” the Federal Reserve is doing is going straight into reserves the banking system holds, and in exchange the FED receives treasury bonds.  If one understands banking, then one would understand that reserves are not and cannot be lent out to anyone.  Nor can it magically enter the economy, as many seem to implicitly imply.  For more information on QE (and preferably before reading any more of this article), read this, and this one as well to understand the mechanics of having a sovereign currency.
So how then has QE helped inflate commodity prices?  Note that I said “helped”.  The answer lies in inducement effects (or effects that influence one to do one thing or another).  The idea of a QE program goes back to Irving Fisher and John Maynard Keynes.  Keynes argued, when referring to the effects of a potential QE/ZIRP program as a response to debt-deflation, that “in a time of slump…a very excessive price for equities is not likely to occur” (Keynes, 1930).  Note well that he refers here to “equities”.  So how can one explain this phenomenon in agricultural and energy (among other) commodities today?  The answer, as I and many others have outlined elsewhere, lies in the fact that energy commodities have become financialized.  Where QE comes into the picture, then, is through the inducement effects it has through interest rates.  The question becomes (as a result of QE): Who wants to earn near 0% on a security?  The financial industry decided that they needed to find a new asset class in their hunt for yield.

Yet to have an effect on commodity prices one needs to have an enormous amount of influence.  The financial sector taken as whole needed a new source of income with consumers deleveraging and unemployed, and one option was to enter commodities.  Hence, ZIRP, QE, and the financial crisis took the financial sector in the only direction it was able to go.   Through successful advertising (and institutional investors and others worried about the potential effect QE may have on inflation), the stage was set for commodity prices to soar.  Goldman Sachs and hedge funds invest in commodities not necessarily with their own funds but through their clients’ funds.  The impetus for doing this on behalf of its clients was 1) the insatiable demand for alternative investments, and 2) to earn fee income for providing this service.  Yet remember also that the drive towards alternative investments like commodities was due to two main factors: financialization, and deleveraging and unemployment in the real sector.

In sum, the argument that QE is directly responsible for the rise in commodities and a range of other assets lacks a transmission mechanism; the key to understanding the determination of commodity prices lies elsewhere.  The useful myth in this entire charade of a debate to justify higher food and energy commodity prices is that there is rising demand and lower supplies.  Yet energy supplies (like oil) throughout the world are plentiful and filled to the brim.  Supply and demand arguments are simply not working here.  In my opinion, this is due to three (sometimes related reasons): 1) The information on food and energy commodities is imperfect and inaccurate; 2) Commodities futures markets rarely result in actual deliveries of the commodity (as explained in my previous post linked to above), and hence convergence between futures and spot prices has no theoretical or economic basis; and 3) the role of price discovery by futures markets is often forgotten, and if futures no longer converge to spot then prices can be divorced from actual supply and demand forces for at least the short to medium run.  Due to these factors and the uncertainty surrounding commodity prices, the futures price has become even more engrained as the benchmark for pricing among commodity producers.  The only thing restricting higher prices is the very thing that created these alternative investments: the lack of income and jobs for consumers.  To ensure that the commodity gravy train lasts for as long as it can, hedge funds, investment banks, and many countries like China have bought large swaths of farmland or oil tankers (or entered into oil leasing contracts with commodity producers to restrict output).  Lower supplies shown on official figures support the futures price and prevent it from collapsing.  Whether a commodity producer uses a spot or futures price as a benchmark for their own pricing doesn’t matter: both prices can lack real fundamentals and/or be manipulated (for spot price manipulation in oil, see this piece).

There are some dissenters to the viewpoint that financialization in futures markets ultimately drives commodity prices.  Some MMT observers see this as simply the case of monopoly/oligopoly pricing power by commodity producers.  While no person can deny that the market for food and energy commodities is inherently oligopolistic, the idea that producers set the price and let quantity adjust ignores all of the detail laid out above, the rapidly fluctuating price, and the seemingly large amounts of supply on the market (at least for oil).  Some non-MMT observers argue that futures markets require someone to go short and to go long, yet misunderstand that investment banks and hedge funds typically take both sides of the trade.  They also argue that futures markets derive their value from spot prices, but as I mentioned above this argument no longer has any basis in reality.  Note that neither I nor the dissenters make any comment about QE: there is no transmission mechanism other than inducement effects to make the argument that it drives commodity prices.

There are many solutions to bringing down high commodity prices (prices which have (helped )produce the Arab Spring (as Egypt is a primary commodity importer) and reduced output and employment worldwide).  The solution that MMT incorporates into its framework is that of the Job Guarantee (JG) or Employer of Last Resort (ELR).   Even in the presence of QE, food and energy commodity prices should slowly begin to reflect fundamentals as investment is driven towards real production rather than to commodities (as a result of higher incomes through an ELR program).  At first blush this may seem counterintuitive, as nothing has been done surrounding the issue of manipulation and speculation.  The existence of higher incomes will increase demand, lower supply, and increase prices.  Yet this ignores the fact that investment is being driven towards commodities due to low returns elsewhere (low yields and high unemployment).  Hence, financialized investment in commodities should slowly drift away as a result of an ELR program.

MMT provides not only a description for why QE has no direct transmission mechanism towards higher commodity prices, but also a prescription for how to lower commodity prices and hence bring price stability.  Ironically enough, it is through an ELR program (where full employment beyond the non-accelerating inflation rate of unemployment is typically credited with inflation in mainstream economics), and not monetary policy or the futures market (both of which respectively are credited for price stability in mainstream economics), that can provide for stability in commodity prices in addition to full employment and output.

I welcome any and all comments, particularly on the theoretical proposition that a JG brings stability to commodity prices.

47 Responses to Quantitative Easing and Commodity Prices: An MMT Approach

  1. I have this little problem with the transmission mechanism. Reserves are there only to faciliate inter-bank payments and are not lent out, banks create credit out of thin air without a prior need for reserves. I’m all fine with that. But I have this question: since after/during the QE banks have much of reserves, why can’t they buy the very same commodity futures or other financial assets and see their reserves being drained as they go to some other institution as a payment. I mean:

    If a bank X has $1,000,000,000 in excess reserves, why can’t it just buy $1,000,000,000 worth of oil futures and see its excess reserves being transfered in the inter-bank market?

    Sorry for a stupid question, but that’s just a missing piece in MMT for me, because I struggle to get why banks can buy bonds and see their reserves being drained as a payment, but cannot do that with other financial assets.

    Thank you in advance.

    • Golfer1john

      An individual bank can do that, but the amount of reserves in the banking system does not change as a result. It just moves around.

    • If you had a house worth $400,000, would you sell it to buy 400,000 $1 dollar chocolate bars in the hope that the price of chocolate bars would go up next week?

  2. Golfer1john

    If the commodity price will be brought down by increased employment and increased return to non-financial assets, why is JG/ELR necessary to do that? Would not an increase in aggregate demand due to some (any?) other cause have the same effect (albeit not to the same extent because it would be limited by NAIRU/Phillips curve)? And is not appropriate fiscal policy part of MMT as well as (and in the minds of some, more so than) JG/ELR?

    • Hi, thanks for the question, one I knew someone would raise.

      An ELR program is by its nature counter-cyclical. All I’m saying is that there is no possibility that investments would go towards commodities if consumers always have a source of income available to them, and a job. There is no need for fiscal policy measures to be enacted, which isn’t always politically feasible.

      • “there is no possibility that investments would go towards commodities if consumers always have a source of income available to them”

        Why?

        • Why would they look for alternative investments if everyone has a job and is earning an income? You have to remember that “investing” in commodities is actually a dangerous maneuver. The only you would ensure that your bet would pay off, as someone investing through the GSCI fund for example, is if you know the only possible price trajectory is upwards, and the only way that would happen is if everyone else was bidding it up too. Why would they invest in something as dangerous as this if they could instead depend upon consumer stocks, or investment in productive capacity (because the outlook for the economy, even if its in a downswing, is not so severe for those forward looking because consumer always have an income available to them even today).

          In my opinion, inequality/the recession and the rise in commodity prices is DIRECTLY RELATED.

          • Golfer1john

            “Why would they invest in something as dangerous as this if they could instead depend upon consumer stocks, or investment in productive capacity”

            1. For diversification. Commodities are touted to be uncorrelated to common stock prices, likely as not to go up when stocks go down.
            2. With hedges, the risk (and the reward, as well) can be limited.
            3. Because commodity producers wish to sell their production in advance, so as to obtain the capital required to produce the output. And to do so, they will often sell at a lower price than the spot price is expected to be at the delivery date, creating opportunity for arbitrage.
            4. Because they think they have a trading “system”, and are looking for larger volatility. Some people DO want to simply speculate. Why do people go to casinos? It can be quite entertaining, even though costly for most.

            Just because one would not put ALL his investable funds into one specific investment does not mean that some people won’t put some of their funds into it.

          • Golfer1john

            “The only you would ensure that your bet would pay off,…”

            And what is the investment where there IS a reliable way to ensure that your bet will pay off?

          • golfer, I’m not saying speculation in general ends (indeed, professional “speculators” who have had their hands in commodities for the past 30 years have existed after all), I’m talking about investment in funds like GSCI or hedge funds who dabble in it now. There is a difference in magnitude here I’m talking about.

  3. Golfer1john

    I see a problem with the analysis. It’s the timing. For most commodities for which I could find charts going back far enough, a multi-year bull market peaked in or close to 2007, and despite QE and ZIRP starting in 2008, they have not (with a few exceptions) reached their prior price levels, and many seem to have peaked again in 2011 and are now heading down, despite the continuation of ZIRP and the continued downtrend in longer-term interest rates.

    With employment rising, stock prices rising, and interest rates rising, from 2002 to 2007, commodity prices rose as well. Obviously not due to money flowing to commodity futures speculation due to low returns in other investments, since returns in other investments were high and getting higher. And now, for over a year, many commodity prices have been trending down, despite the continued low returns in bonds and alternative real investments.

    I just don’t see data justifying the conclusion that either QE or speculation has caused long-term upward movements in commodity prices. The correlation seems to be negative, if anything.

    • Commodity prices can only go as high as what the consumer can bear. Furthermore, there is a psychological limit now to how high one would be willing to drive up commodity prices due to what happened in 2008. Nobody wants to get wiped out.

      As far as the timing, the timing of the fall in housing prices and financial derivatives linked to them is more or less coincident to the timing of the rapid rise in commodity prices. Now whether one wants to say QE was at all responsible, all I’m saying is that if you want to blame QE/ZIRP, you can only blame it through inducement effects, there is no other transmission mechanism available.

      • An “inducement effect” is a transmission mechanism.

        • You can’t say “QE had no effect, because it’s just an asset swap – apart from the effect of inducing people to move their funds into speculative commodity markets, thus fueling inflation.” Doesn’t really work.

          • It can induce investors to invest in anything. Today, commodities just happened to be the asset class of choice.

            Look, when I refer to transmission mechanism, there has to be a direct link for the reserves entering the banking system to enter into commodities. This is what most people refer to when they blame QE for the rise in commodity prices. In my opinion, an inducement effect is not a transmission mechanism. It’s honestly ridiculous to call this a direct transmission mechanism.

          • I agree the idea that reserves might somehow get “out” into the economy is wrongheaded. But still, the effect of QE was to reduce risk-free interest income at a time when other sources of income were drying up. This had the effect of pushing more “investors” towards speculative markets to try and make money (inc. gold market I suppose). I agree that if better policies had been pursued to maintain income and re-boot the economy, then there would have been an incentive to invest in more productive things. That’s a really good point (though it would probably take more than just the JG however – Mosler’s other proposals, for example).

            But at the time MMTers were all saying “QE can’t cause inflation because it’s just an asset swap, so there’s nothing to worry about”. Then it turned out that QE had the effect of changing investment portfolios in a way that actually DID contribute to inflation, via higher commodity and energy prices.

            As Golfer points out, having a booming economy is no guarantee against commodity speculation in itself. This might actually be exacerbated by a zero interest rate policy (advocated by MMTers), just as low interest rates helped to fuel speculation in real estate.

          • I agree with all your comments completely. I myself recognize, as do MMT’ers in general (understanding Minsky and Bill Black’s arguments) that good regulation is always a necessity if we’re talking about maintaining for the most part the system (capitalism) as it exists today, which is why we talk about that too. I didn’t bring up regulation etc, just for the sake of argument. I also recognize that a JG alone probably wouldn’t suffice to prevent speculation in alternative markets.

          • I should also add, that if you have a theory of the state, whereby those in power will seek to maintain it, then all analysis leads back to that of inequality. Without tackling inequality, one will have weak regulation, increased speculation in financial markets, more financial crises, and even stronger inequality if the powerful can manage to get the state to save them.

            One institutionalist, Jamie Galbraith, explicitly recognizes this, which is why his last two books were: The Predator State, and his latest book on inequality.

          • To characterize it this way also fits in with the traditional surplus approach in economics, where the surplus is directed not towards growing the economy but towards speculation and finance. This in turn can have other effects which I have written about elsewhere.

          • I suppose you’re right that inequality in the wider sense generates the sort of financial profiteering that benefits no one but those with the resources to a) neutralise government intervention, and b) manipulate markets to their advantage.

            I think that in order to limit potentially damaging speculative behaviour in crucial commodity markets, we need to set tight rules on what powerful financial institutions/ investors can and can’t do. If, at the very least, we could stop large investment funds from distorting commodity markets, by simply banning them from speculating on them (we could start with pension funds), then that would be a big step forward. But that would require an executive that was less in hock to established financial interests – i.e. taking back our democracy from those who seek to pervert it for their own economic advantage.

      • Golfer1john

        “As far as the timing, the timing of the fall in housing prices and financial derivatives linked to them is more or less coincident to the timing of the rapid rise in commodity prices.”

        I disagree. Housing prices rose from 2002 to 2007, and during that same time commodity prices were also rising strongly to all-time highs.

        Housing prices pretty much crashed in 2008, at the same time commodity prices crashed.

        From 2009 to 2011, housing prices were mixed, falling in the markets where they had risen the most before 2008, but beginning to recover in more “average” markets. Commodity prices were rising.

        In 2012, housing is experiencing a broader (though still weak) recovery, but commodities continue their decline since the highs in early 2011.

        The correlation is inconsistent, but certainly not inverse, as you claim. In fact, the period that you cite of the fall of housing prices is the time when the positive correlation is the strongest: both housing (and the derivatives tied to it) and commodity prices were crashing together.

  4. QE also barely moved interest rates when it was implemented.

    • Although I understand traders would be left with cash instead of an interest earning bond. However, banks that made the trade received reserves that earn interest, albeit at a lower rate.

      However, I think this point means this statement from the article is inaccurate: “All of the “money printing” the Federal Reserve is doing is going straight into reserves the banking system holds, and in exchange the FED receives treasury bonds. ”

      Non-banks trade bonds as well. It’s not just Fed vs banks.

      • Precisely. If an individual who owned a bond sold it to the Fed, they would receive a deposit in their bank account, and the bank would recieve reserves. The idea that QE is just between the banks and the Fed is wrong.

        • Yes, it was my mistake to not broaden that statement, but it means nothing in terms of the message I was trying to send in this piece (doesn’t change it)

  5. Dan Kervick

    I’m not sure I follow this whole argument Payam. But have you distinguished QE1 from QE2? QE1 involved the purchased agency securities and mortgage backed securities, and not just Treasury securities, right? So isn’t there a potential transmission mechanisms there?

    • Hi Dan, I do have a link in the article to something I wrote over a year ago, to kind of introduce you to the way I see things. That may help you out.

      In terms of QE1/QE2, I’m aware of the difference but I honestly felt it made no difference…because the reserves the Fed creates (whether to banks or individuals) doesn’t magically appear in the economy. Regardless, its effect on the term structure may in fact induce individuals and others to invest in alternative investments. Whether this should be called a transmission mechanism I’m not sure.

      • If the central bank buys up privately created ‘junk assets’, such as mortgage backed securities, then it does actually make it possible for the previous owners of those “assets” to bid up prices in other markets. Before the CB intervened, they were holding pure junk that they couldn’t offload. Following the CB’s intervention, they had new liquid triple-A NFAs, that could be put to work elsewhere. So the CB’s intervention in this case clearly changes things – it’s not just a insignificant “asset swap”. It’s also a form of socialism for the rich once again: “Oh, your bets turned bad? Don’t worry, we’ll take the risk on to our books – here’s a load of new spending money. Have fun!”

        • Admittedly, if they did buy the JUNK and not just the MBS that would have been appropriate for say a Fannie or Freddie, then that would be true. I assumed they bought the latter. Whether they did or not I don’t know…

          • Golfer1john

            Fannie and Freddie went bust, too, apparently because they also held “junk”. But the Fed is claiming that they have sold the “junk” they bought from the banks at a profit, and some claim that it was never “junk”, but true AAA paper all along, and the banks were not “bailed out” at all. Since the whole thing was so “opaque” to begin with, it is hard to tell. One thing for sure, the banksters made out like bandits, keeping their ill-gotten bonuses for creating the “junk”, and then keeping their jobs and their freedom even after their shenanigans caused the GFC.

          • All thanks to the Fed’s intervention. You can’t just pass it off as a nothing asset swap. These guys were going down before because of all the shite on their books.

  6. Golfer1john

    So (out of reply links on the relevant thread) are you just saying that the rise and fall of commodity prices is due more (than physical supply and demand changes) to inflows and outflows of funds to the relatively new (long) ETFs, ETNs and mutual funds that track, or attempt to track, commodity prices?

    • If commodity producers use futures as a benchmark, which I believe they do and (theoretically) would in a time of rising prices, then it certainly has an impact. On the other hand, financialization of commodities has occurred not only through derivatives markets but also on the spot market. From keeping oil in the ground (one argument chris cook has made is that oil producers are leasing their oil to GSCI and others), to restricting output of other commodities (hedge funds/China buying up farmland or oiltankers), these together help keep the price of commodities higher than one would believe they would or should be.

      • Golfer1john

        I don’t get the part about buying up farmland. Are you saying the new owners are idling the farmland, and that drives up prices? Would not that be a real change in supply?

        • Yes, and it is a real change in supply, but those effects are just to reinforce the futures price to ensure it stays relatively stable at a relatively high price…they don’t want to see a change in perception to cause a massive fall in the price that drives everyone out of commodities. The reason for this is that GSCI and others earn a fee from having more and more investors in their funds.

        • Either way, the point is financialization is the problem here.

  7. “The financial industry decided that they needed to find a new asset class in their hunt for yield.”

    Including the euro.

    Remember when the Chicago Merc Exchange required a hair cut on US Treasuries on deposit after the US was downgraded over the debt ceiling stand off?

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  9. From a wikipedia article on contango:
    “Exchange-traded funds (ETFs) provide an opportunity for small investors to participate in commodity futures markets, which is tempting in periods of low interest rates. Between 2005 and 2010 the number of ETFs rose from two to ninety-five, and the total assets rose from 3.9 to nearly 98 billion USD in the same period.”
    A lot of small investors lost on this. But it shows the move to commodities pretty clearly. The GSCI index is 78% energy.
    and this:
    “In 2005 and 2006 a perception of impending supply shortage allowed traders to take advantages of the contango in the crude oil market. Traders simultaneously bought oil and sold futures forward. This led to large numbers of tankers loaded with oil sitting idle in ports acting as floating warehouses.[4] (see: Oil-storage trade) It was estimated that perhaps a $10–20 per barrel premium was added to spot price of oil as a result of this.”
    Sure make a lot of money on this trade, especially at that time, I would guess. I note also that the GSCI was a goldman index before it was S&P.

  10. Sean Fernyhough

    The Bank of England explanation of the QE mechanism explicitly rules out the multiplier effect of the extra reserves being held by the banking system. In fact it emphasises that the main affect is seen as a portfolio affect for non-bank holders of government debt. Excess balances of cash mean that these agents buy other assets (assuming that cash and gilts are not seen as substitutes), bidding up the price. A general rise in asset prices means that people feel more wealthy and so spend more.

    • It’s not really excess cash balances, more the fact that they earn such a low return at present. If you own a govt bond you can sell it any time at short notice. Owning a bond does not stop you from spending or investing elsewhere if you want to, so QE didn’t make it easier for people to spend or invest. What it did is bring down yields and push up bond prices. Low yields and interest rates encourage people to shift investment into corporate bonds, equities, and also commodities. The first two are ok, the last not so good. Lower govt bond yields are also supposed to lead to lower corp bond yields, making it cheaper for businesses to borrow. Supposedly higher asset prices have a wealth effect, causing people to spend more. Overall spending is down though – QE doesn’t actually lead to higher aggregate demand, just temporarily higher asset prices and (probably?) higher commodity prices. The latter can feed through to higher inflation, though probably temporarily as demand is low.

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