The Fed Should Be Ready to Backstop the Commodities Market
Justified as they are, the sanctions imposed on Russia are wreaking havoc on already-strained commodities markets
(Bloomberg Opinion) -- Justified as they are, the sanctions imposed on Russia — one of the world’s largest exporters of metals and hydrocarbons — are wreaking havoc on already-strained commodities markets, with potentially dire consequences for the global economy. To avoid unnecessary damage, officials should be prepared to meet this extraordinary challenge with a no less extraordinary response: Emergency support from the U.S. Federal Reserve.
In recent weeks, uncertainty about how the war and sanctions will affect supply has led prices of everything from oil to nickel to gyrate wildly, in some cases more than doubling in a matter of days. The volatility has, in turn, prompted lenders and clearinghouses to demand more collateral to back market participants’ rapidly expanding positions, in some cases boosting cash demands tenfold. Combined with supply-chain snarls, which have increased the volume of commodities in transport, this has placed extreme stress on the finances of some of the world’s largest trading firms, such as Glencore, Trafigura and Vitol — stress that recently forced the London Metal Exchange to shut down nickel trading to avert a cascade of defaults.
The repercussions could be far-reaching. Trading firms play a central role in ensuring that supplies reach end users. If they can’t borrow the money needed to maintain their positions, production of goods ranging from gasoline to electric cars could suffer, further aggravating price spirals and logistical issues. Food shortages, rationing and power outages are not beyond the realm of possibility.
Central banks were created to address such market failures. By providing emergency loans against good collateral, or by standing ready to purchase assets directly, they temporarily replace private financing until the crisis passes. That’s what both the Fed and the European Central Bank did at the onset of the coronavirus pandemic, with the Fed extending its support all the way to the markets for municipal bonds and corporate debt. Typically, the mere promise of support is all that’s needed to get markets functioning again.
So far, though, central bankers have been reluctant to backstop the commodities market. The ECB rebuffed a call from the European Federation of Energy Traders to provide emergency funding for exchanges and clearing members, on the grounds that its statutes don’t allow such support. But what about the Fed? Section 13(3) of the Federal Reserve Act grants it the power to enter credit markets above and beyond its standing authority to lend to banks. It can, and should, stand ready to use that power to head off a commodities disaster.
Section 13(3) demands that three relevant conditions be met: The circumstances must be “unusual and exigent,” its lending must be amply secured to protect taxpayers from losses, and borrowers must be otherwise “unable to secure adequate credit accommodations.” Certainly, a war in the middle of Europe counts as exigent. Market participants have ample assets to pledge, and their struggles to obtain adequate financing are at the core of the crisis. The problem isn’t that the assets have become impaired — on the contrary, the main driver of the financing gap is a sharp increase in prices.
Granted, there’s a danger that central bank support would encourage participants to act irresponsibly in the future. To mitigate this moral hazard, the Fed would have to clearly communicate that it was responding to a specific financial breakdown, not to normal fluctuations of prices or credit risk. The intervention would not be about rescuing participants from their own risk-taking behavior, but about restoring the market’s ability to price and trade risk amid a global emergency.
No doubt, rescuing the likes of commodities traders would not be a popular move. But that can’t be the Fed’s primary concern. This crisis threatens its mission of ensuring stable prices and full employment. It should be prepared to step in at a moment’s notice.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Steven Kelly is a research associate at the Yale Program on Financial Stability.
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