Did Easy Money in the Dollar Bloc Fuel theGlobal Commodity Boom?
by Christopher Erceg, Luca Guerrieri andSteven Kamin

Federal Reserve Board
September 2010
The views expressed in this paper are solely
the responsibility of the authors and should
not be interpreted as reflecting the views ofthe Board of Governors of the Federal
Reserve System or of any other person
associated with the Federal Reserve System.

The Global Runup in Commodity Prices• Understanding the sources of commodity
price fluctuations remains an important issue for policymakers:–commodity price surge in 2007-2008 exacerbated financial crisis, in part by constraining monetary policy.
– renewed runup in prices could weaken
recoveries in oil-importing countries, andwiden current account deficits.
– volatility in oil and commodity prices posesa challenge for monetary policy, especiallyfor inflation-targeters.

Explanations for (pre-crisis) Commodity PriceBoom• Real Shocks to Demand/Supply (“Fundamentals Based”)– demand for commodities boosted by rapid
industrialization in emerging markets– 80 percent of rise in world oil consumption over 2000-2006 attributable to faster
growth in emerging markets– supply of commodities grew (unexpectedly) slowly, especially over 2004-2007 when
demand was growing rapidly.

Explanations for (pre-crisis) Commodity Price
Boom• Accomodative Monetary Policy in UnitedStates and other industrial countries.
– to extent that accomodative policy reflected “policy innovations” (i.e., departures from a Taylor rule), lower policy rates
boosted aggregate demand and stimulate
demand for commodities.
– reduced cost of holding inventories also
increased demand and contributed to higher
prices.
–but accommodative policy not likely of itself to explain boom in 2007-2008 when
the U.S. was cutting rates in response toadverse shocks.

Explanations for (pre-crisis) Commodity PriceBoom• Dollar Bloc Story– Many emerging market economies, especially in Asia, pegged to the dollar – “thedollar bloc”– Loosening of U.S. monetary policy meantthat dollar bloc countries had to loosen
also.
– Looser U.S. policy fueled an excessive
rise in demand in emerging markets, since
low interest rates were inappropriate forthese fast-growing commodities; and higher
overall demand caused commodity pricesto surge.Martin Wolf Quote (Financial Times, 2008)• ”Today the hapless Federal Reserve is trying to re-expand demand in a post-bubble
U.S. economy. The principal impact ofits monetary policy comes, however, via a
weakening of the U.S. dollar and an expansion of the emerging economies linked toit.”

SIGMA: Three Country DSGE Model• Closed economy features similar to models of Christiano, Eichenbaum, and Evans(2005) and Smets and Wouters (2003).

• Specification includes external habit persistence in consumption, and investment adjustment costs that depend on change ininvestment.

• Calvo-style nominal wage and price rigidities, with full dynamic indexation in wage
and price-setting.

SIGMA: Three Country DSGE Model• Government spending is exogenous, withlump-sum taxes adjusted to satisfy the government’s intertemporal budget constraint.
• Each country produces a distinct basket
of non-oil goods that it trades with othercountries.
• Prices of traded goods are set in currencyof buyer (i.e., local currency pricing as in
Devereux and Engel), and adjustment costs
make it costly to adjust trade shares.
• Some simplifications relative to some variants of SIGMA: desired markups are fixed,
all households are Ricardian, and no financial frictions.

Three Country Blocks• U.S. Block:– 25 percent of world GDP– policy interest rates set by modified Taylor rule with interest rates smoothing, andwhere activity measure is four quarter GDP
growth.
• Developing Asia/Latin America Block (DALA):– 20 percent of world GDP– in benchmark, currencies pegged to U.S.
dollar (but also consider Taylor rule).
• Rest of World Block (ROW):– 55 percent of world GDP– follow Taylor rule, currencies float.

Oil Sector• World Oil Supply– each country block has fixed endowment;
U.S. endowment is 33 of its steady state
consumption, and DA-LA block 60 percent.
• Global Oil Demand– oil is both an input into production, andinto the household consumption bundle. –costly to adjust oil share for both firms/households
in response to relative price changes.
– oil demand responds immediately to changes
in gross output or aggregate consumption.
– very slow response of oil share to relative
price changes (half-life 10 years); elasticity.05 after 4 quarters, 0.5 in long-run.

Monetary Policy Loosening following Adverse
Shock• SIGMA simulation in which an adverse U.S.
aggregate demand shock causes U.S. policy rates to fall by 200 basis points relativeto baseline.
– similar to actual decline in funds rate relative to baseline in 2001-2003 period following tech recession, and in first threequarters of 2008.

• Consider two different assumptions about
monetary response in DA/LA (peg in benchmark, Taylor-rule in alternative).

Monetary Policy Loosening following Adverse
Shock (con’t)• Under DA-LA peg, persistently low U.S.
nominal interest rates cause DA/LA rates
to fall, which boosts output and inflation.
– the GDP boom in DA/LA is transient,
as their exports become less competitive,
and because inflation turns negative (thereal exchange rate overshoots, and must
depreciate).
• The simulation can account for a transient
rise in world oil prices, but it dies away
quickly.
• Key feature of actual runup in oil prices
was that price increases were expected topersist (as inferred from futures market observations).

Figure 8: U.S. Aggregate Demand ShockFigure 5a: U.S. Aggregate Demand ShockForeign Real GDP

Foreign Real Exchange Rate
Percent dev from ss

Percent dev from ss

1.5
10.5
0−0.5

51015

864
2020

1.5
10.5
0−0.5
−151015

Percent dev from ss

Perc pt dev from ss

1015204321510

Foreign Absorption
Percent dev from ss

Perc pt dev from ss

20−4020

0−0.5
−115

15−3

Foreign Policy Rate (AR)10Quarters

20−2

Foreign Real Imports−4515−15−2152002001015

1Foreign Headline Inflation (AR)

510Foreign Real Exports
Percent dev from ss

Perc pt dev from ss

Foreign Core Inflation (AR)520DA−LA Peg

21.5
10.505All Taylor

10Quarters

Figure 5b: U.S. Aggregate Demand Shock (DA Responses)
DA−LA Real Exchange Rate
Percent dev from ss

Percent dev from ss

DA−LA Real GDP
432
10−151015

210−1−2−320

5420−2−4510201515201520

1520

10−1−220

5DA−LA Headline Inflation (AR)10DA−LA Real Imports

10Percent dev from ss

Perc pt dev from ss

15DA−LA Real Exports
Percent dev from ss

Perc pt dev from ss

DA−LA Core Inflation (AR)1050−54321051015

20

5DA−LA Absorption

0Percent dev from ss

Perc pt dev from ss

DA−LA Policy Rate (AR)−1−2−3−4−5510Quarters

15

10543210

20

5DA−LA Peg

All Taylor

10Quarters

Figure 5c: U.S. Aggregate Demand Shock (ROW Responses)
RO Real Exchange Rate
Percent dev from ss

Percent dev from ssRO Real GDP
0.4
0.3
0.2
0.1
0−0.1
5101586420200.2
0.1
0−0.1
−0.2
−0.3
51015

Percent dev from ss

Perc pt dev from ss−3−420152021510RO Absorption
Percent dev from ss

Perc pt dev from ss

15

3020

0.2
0−0.2
15204RO Policy Rate (AR)10Quarters

10RO Real Imports−2515−45−1

15

20−220010150

RO Headline Inflation (AR)510RO Real Exports
Percent dev from ss

Perc pt dev from ss

RO Core Inflation (AR)520DA−LA Peg

10.5

05All Taylor

10Quarters

Monetary Policy Innovations• Monetary policy innovations – departuresfrom a Taylor rule – may have played asubstantial role in fueling excessive growthin domestic demand over the 2004-2006
period (Taylor).

• Second simulation investigates the effects
of a 200 basis point innovation to the U.S.
monetary policy rule (in line with estimatesof the deviation of actual policy from aTaylor rule in early 2004).

• U.S. and foreign output rise in responseto this shock, but effects on world GDP
are transient. Again, the model can explain some increase in oil prices, but not
the persistence.

Figure 4: U.S. Monetary Policy Shock
U.S. Real Exchange Rate
Percent dev from ss

Percent dev from ss

U.S. Real GDP
0.4
0.3
0.2
0.1
00
−0.5
−1−1.55101520

5

1.5
1
0.5
05

1015

−0.1
−0.2
−0.3
−0.4
−0.5
5

−0.5
−1−1.5−215

10152015201520

World Aggregate GDP
Percent dev from ss

Perc pt dev from ss

U.S. Policy Rate (AR)10200200515U.S. Trade Balance (GDP share)Perc pt dev from ss

Perc pt dev from ss

U.S. Headline Inflation (AR)

100.2
0.15
0.1
0.05
0205U.S. Real Rate (ex ante, AR)

10U.S. Real Oil Price
Percent dev from ss

Perc pt dev from ss

0−0.5−1−1.5−2510Quarters

1515
1050

20

5DA−LA Peg

All Taylor

10Quarters

Higher Foreign Productivity Growth• Positive shock to foreign productivity growththat boosts foreign GDP growth about 1.5
percentage points above baseline very persistently.
– This shock is consistent with a rise inworld growth to 5 percent during 20042007, about 1 percentage point higher than
average in the preceding 2 decades.
• Long-run rise in world output of 35 percent boosts oil price by 70 percent. –However, price jumps immediately reflecting that even small rise in demand initiallyhas large price effect given low elasticity– Subsequently, fall in demand due to gradual price substitution almost exactly balanced by higher demand.

Figure 10: Foreign Technology Growth ShockFigure 11: Foreign Technology Growth ShockLower Growth of Oil Production• Negative shock to supply that lowers growthof global oil production 1.5 percentage points
baseline baseline.
– Consistent with a fall in growth of world
oil production from about 2 percent annually to 1/2 percentage point during 20042007.
–Long-run fall in oil production of about
30 percent.

• Persistent adverse shocks to growth rate ofsupply can explain highly persistent decline
in the relative price of oil.

Figure 12: Negative Oil Supply ShockFigure 13: Negative Oil Supply ShockFigure 15: Combined Positive Foreign GDP and Negative Oil Supply Shocks

How Realistic is the “Dollar Bloc” Premise?

• Currencies of East Asian countries do showless volatility relative to the dollar than mostindustrial country currencies. Even so, thewon moves about as much as the pound orpeso.

• Policy interest rates of East Asian currencies show little comovement with U.S. policy rates, weakening case for a dollar bloc.

Conclusion• “Dollar bloc” story can account for transitory increases in oil prices, but not the very
durable runup that occurred between 2002
and 2007.

• Faster GDP growth in emerging market
economies and sluggish expansion of capacity better explain the sustained rise inoil prices.

• The “dollar bloc’ appears less rigidly tied
to the dollar than the name suggests.

Conclusion• It remains difficult to account for some features of oil/commodity price behavior:– the astounding runup in prices in 20072008 amidst financial turmoil in industrial
countries.
– the enormous drop in spot prices relative
to future in early 2009.

• More sophisticated models of oil/commodity
market behavior are desirable, including models that include oil inventories (Bodensteinand Guerrieri), and endogenous determination of oil supply.