By Dragan Miljkovic, Professor NDSU Agribusiness and Applied Economics Department

Since 1978, the Federal Reserve Bank of Kansas City has hosted an annual economic policy symposium. The event is designed as a forum for central bankers, policy experts and academics to come together to focus on a topic that is not necessarily of immediate concern, but instead looks at future emerging issues and trends.

At the 2016 symposium held in August, Janet Yellen, the chair of the Federal Reserve Board, presented a speech titled “The Federal Reserve's Monetary Policy Tool Kit: Past, Present and Future.” Her focus was on the policy tools needed to ensure that we have a resilient monetary policy framework. In particular, she focused on whether the Fed’s existing tools are adequate to respond to future economic downturns.

Yellen argued, “One lesson from the crisis is that our pre-crisis tool kit was inadequate to address the range of economic circumstances that we faced. Looking ahead, we likely will need to retain many of the monetary policy tools that were developed to promote recovery from the crisis. In addition, policymakers inside and outside the Fed may wish at some point to consider additional options to secure a strong and resilient economy.”

The importance and the impact of monetary policy on commodity prices has long been recognized. Most research has focused on the exchange rate as the sole mechanism of transmission from monetary policy to commodity prices, with an emphasis on agricultural commodities.

The importance of the exchange rate, especially given the importance of international markets in commodities trading, should not disguise the point that monetary policy has effects on real commodity prices, even in a closed economy. For example, an increase in the expected economy wide inflation rate due to an increase in the money growth rate causes investors to shift out of money and into commodities.

As a consequence of the increased demand for commodities, expected future inflation has a positive effect on commodity prices in the present. On the other hand, an increase in the nominal interest rate in excess of the expected inflation rate (that is, an increase in the real interest rate) due to a decrease in the level of the money supply or to a fiscal expansion causes investors to shift out of commodities and into bonds. It thus has a negative effect on commodity prices. Therefore changes in monetary policies by the Fed may have a large impact on North Dakota’s agricultural sector.

Fossil fuels, including coal, oil and natural gas, also are subject to these monetary policy impacts, but, curiously enough, have not been subject to this analysis. The case of coal is of interest for the U.S. and North Dakota in particular because the U.S. has long been self-sufficient in coal consumption, and overall small net-exporters. Not more than 2 percent of domestic coal consumption has been imported, while less than 10 percent of domestic production has been exported in recent years.

Monetary policy in the U.S. has been diverse during the last 30 to 40 years. For instance, as economic theory would predict, when monetary policy became more rule like and focused, the performance of the macro-economy improved, and when policy reversed, so did economic performance. The inflation rate declined from the peaks reached during the great inflation of the late 1960s and 1970s, which required changes in monetary policy. The Fed’s policy interest rate, the federal funds rate, was much higher in 1989, when it was 9.7 percent, than in 1968, when it was 4.8 percent, even though the inflation rate and business cycle conditions were about the same.

The larger response of the interest rate was a regular, predictable characteristic of monetary policy in the 1980s and 1990s, compared with the earlier period. It is one of the best ways to indicate that policy changed, leading to less inflation and ushering in the so-called Great Moderation.

To illustrate the shift back in monetary policy, notice that the federal funds rate was only 1 percent in 2003 while it was 5.5 percent in 1997, even though the inflation rate was the same in 2003 as in 1997 and the overall level of utilization in the economy was similar.

In other words, the Fed deviated significantly from the type of policy that had worked well in the 1980s and 1990s by keeping the interest rate very low. This was a change that characterized the whole 2003 to 2005 period, which some now call the “too low for too long” period.

Yellen’s words about the outlook of monetary policy by the Fed have not been very clear or direct, stating, “And, as ever, the economic outlook is uncertain and so monetary policy is not on a preset course. Our ability to predict how the federal funds rate will evolve over time is quite limited because monetary policy will need to respond to whatever disturbances may buffet the economy.

“In addition, the level of short-term interest rates consistent with the dual mandate varies over time in response to shifts in underlying economic conditions that are often evident only in hindsight,” she added. “For these reasons, the range of reasonably likely outcomes for the federal funds rate is quite wide.”

Thus, the impact of monetary policy on agricultural and fossil fuel commodities is difficult to predict at the moment, given the uncertainty about monetary policy itself in the year or years ahead of us. We need to keep a close watch on potential changes in monetary policy to help us better predict its potentially large impacts on commodity prices.

NDSU Agriculture Communication - Sept. 15, 2016