From the July 2008 issue of Boomer Market Advisor • Subscribe!

Commodities generating a lot of hot air

Are we or aren't we? In a bubble, that is. That's the question many are asking about the current commodities markets. Skyrocketing prices have many thinking it's too good to be true, and the bubble is in fact growing. According to the Wall Street Journal:

In commodity markets, what is traded aren't physical commodities but contracts that are essentially bets on where prices will go, Harvard economist Greg Mankiw says. The final effect of the bets is limited unless they encourage speculation in the commodity itself - encouraging, say, a coffee broker to warehouse coffee in hopes of getting a higher price later.

And that is what is happening, according to Mankiw's Harvard colleague Jeffrey Frankel, who says such speculative behavior is due to the sharp reduction in interest rates by the U.S. Federal Reserve. Low rates encourage commodity stockpiling, he says, by making it less attractive to sell commodities and put the proceeds into bonds and other debt instruments.

Others aren't so sure, and the Journal reports critics of Mr. Frankel's theory say the expected rise in commodity inventories hasn't shown up. Frankel has acknowledged that, but also notes that perhaps oil producers are leaving those inventories in the ground. That could be one reason why the Saudi king rebuffed U.S. President George W. Bush's request for increased oil production earlier this month.

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