One striking feature of the economic landscape over the past few months is how sharply asset and, particularly, commodity prices have rebounded from their troughs of late 2008 and early 2009. For example, crude oil prices, which had dropped below $40 per barrel when there were widespread expectations that the global economy was entering a deep and prolonged recession, have rapidly reached the $80 mark in recent weeks and threaten to go higher. Even though economic conditions have improved during this period, they have hardly done so to the extent that one would expect such a rebound in the prices of oil and other commodities. From the perspective of demand-supply balance, in most sectors it is still a buyer’s market, with capacity utilisation levels nowhere near the peaks achieved in the pre-crisis boom. So, something else is obviously at work. One plausible explanation is that the massive policy response to the crisis by central banks and governments has pumped enormous amounts of liquidity into the global financial system, without a commensurate increase, as yet, in the demand for funds to finance actual production activity. The overhang of liquidity is flowing into various channels, including various commodity markets, by way of surging investments in commodity futures.
This brings the role of this instrument into the spotlight. There is no question that the development of commodity futures markets has played a very significant role in making global agriculture more productive and more stable. Futures provide producers and users the ability to respond more effectively to price signals as well as to protect themselves against price risk. Nowhere in this story does it say that increasing activity in futures markets will, per se, have an impact on the current prices of the commodity in question. However, many people suspect that this linkage is now emerging. For example, a study published in December 2008 by a team of researchers associated with the Commodity Futures Trading Commission, which regulates these markets in the US, suggests that a strong link between the prices of long-dated futures and short-dated futures (which are, in turn, reflective of current prices) emerged around 2004. The main reason for this, they think, is the entry of a different class of buyers — specifically, hedge funds and other financial traders. Essentially, the entry of participants other than producers who were merely using these instruments to hedge against price risk seems to have created a linkage between the prices of long-dated futures and the current price. If this is the case, the traditional demand-pull explanation for the link between money growth and inflation now needs to be supplemented with a cost-push story as well; liquidity flowing into commodity futures markets may be stoking inflationary pressures by driving the current prices of these commodities up. Of course, these linkages need to be probed further but, meanwhile, they do have regulatory implications. Perhaps traders, who neither represent producers nor users, need to be restricted in their participation in these markets.