Fred Furlong

English

Research Papers in Economics

FRBSF WEEKLY LE1IE~
June 16, 1989
Commodity Prices and Inflation
With the jumps in consumer and producer prices
earlier this year, inflation is now running above a
six percent annual rate, compared to around four
percent last year. Many wonder whether the
economy is headed for even higher inflation,
while others contend that inflation could subside
in comingmonths. To get a reading on the direc-
tion of inflation, many analysts and policymakers
used to look at the growth rate of the M1 mone-
tary aggregate, since movements in this aggre-
gate preceded movements in inflation in a fairly
reliable fashion. These days, M1 no longer ap-
pears to be a reliable guide, making the course
of inflation harder to predict. As a result, analysts
and policymakers now form opinions about infla-
tion after considering a wide array of economic
variables, including labor market conditions
(such as changes in employment, the unemploy-
ment rate, and wages), movements in the foreign
exchange value ofthe dollar, real economic
growth, growth in the M2 or M3 monetary aggre-
gates, changes in private debt, and even past
rates of inflation.
In addition to these "indicators:' some also look
at one or more commodity price indices to help
them predict inflation. This Letter discusses why
commodity prices might be useful indicators, as
well as some of the problems with using com-
modity prices as leading indicators of inflation. It
then evaluates empirically the improvement in
inflation forecasts that a commodity price index
can make.
The role of indicator variables
It takes about 18 months for a change in the
direction of monetary policy to have a measur-
able impact on the price level. Because the
effects of policy are not seen immediately, policy-
makers seek reliable leading information on the
trend in prices to determine whether policy is
on the right course. For this purpose, they use
indicator variables. Trends in these variables bear
some relationship to trends in overall prices and
so; are useful in predicting.inflation.
However, indicator variables are not operating
targets the way M1 once was. Because the Fed-
eral Reserve does not set target ranges for these
variables, their movements do not dictate any
particular path for policy, but merely help to
suggest whether the current policy stance is
appropriate.
The supporting case
Some have argued that commodity prices, or an
index ofcommodity prices, have several advan-
tages when used as a leading indicator of infla-
tion. First, commodity prices are reported on a
morefrequent and timely basi5 than arethein-
f1ation indexes themselves. Commodity price
quotes are available daily, while the CPI is availa-
ble only monthly and the GNP price indices are
available quarterly. More importantly,commodity
prices are flexible and adjust more qUickly to
changes in underlying fundamentals than do
overall prices. Commodity prices adjust rapidly
because many commodities are traded daily in
highly active and sophisticated international spot
markets.
Finally, commodity prices may be a good leading
indicator of inflation since commodities are basic
inputs to the production process. It is reasonable
to expect shifts in aggregate demand to be re-
flected in the prices of commodities before those
of finished goods.
Indeed, Professor Jeffrey Frankel has shown that
commodity prices initially should reactmore
than proportionally to certain shocks such as a
changein the supply of money. For example, if
the money supply were to decline, the prices of
all goods, includingthose of commodities,
would be expected to fall proportionally in the
long run. However, prices of some goods may
adjustslowly in the short run,leavingthe price
level high relative to the new level of the money
supply. As a consequence, interest rates could
rise in the short run. The temporarily higher
returns on financial assets would encourageFABSF
Percent
15
Chart 2
12-Month Moving Average Changes
Percent
70
50 12
30 9
10 6
-10 3
-30 0
1964 1968 1972 1976 1980 1984 1988
provides some perspective on this question. By
focussing on 12-month moving average growth
rates, the chart enablesusto discern better the
movements in commodity prices apart from the
highly volatile month-to-month spikes in their
growth rates. The chart shows that turning points
in the growth rate ofthe CRBI always preceded
peaks and troughs in CPI inflation. Thus, there is
some evidence that the index could be useful as
a leading indicator. Its lead over inflation, how-
ever,. is not all that reiiable. With a mean lead of
about 11 months, the lead in the turning points of
the CRB index ranges from two months to 20
months.
The VAR results show instability in the relation-
ship between the commodity price indices used
and the CPI. That is, even when the effects of
other macroeconomic variables are taken into
account, swings in the inflation rate have tended
to be much larger relative to a commodity price
shock of given size after 1975 than before the
mid- 1970s. Chart 2 also shows this instability;
the rise and fall in CPI inflation relative to the
changes in the growth rate of the CRBI were
much larger in the late 1970s and early 1980s
than in the early 1970s. Such instability poses
Statistical evidence
Ultimately, the framework provided by
macroeconomic models is needed to determine
whether a commodity price index can improve
policymakers' ability to explain and predict
inflation. One study, reported in the Winter 1989
issue of this Bank's Economic Review, uses a
vector autoregression (VAR) to predict inflation.
The VAR includes a commodity price index along
with variables like M2, unemployment, GNp,
exchange rates, and interest rates.
Percent
200
160
120
80
40
0
-40
-80
-120
1984 1988 1980 1976
Commodity
/' Price Index
1972
But, over longer perio"ds of time, do changes in
commodity prices reliably lead inflation? Chart 2
Chart 1
Annualized·Monthly Changes
Over the period covered by the chart, the
standard deviation of the monthly growth rates
for theCRBI is almost 10 times larger thanthat for
the CPI, even though the mean growth rates are
notmuch different; growth in the CRBI averaged
4.7 percent, while the CPI averaged 5.5 percent.
This volatility is not uniqueto the CRBI. Monthly
growth rates for every well-known composite
commodity price index vary much more than CPI
inflation. This greater volatility makes it difficult
to discern from short-run movements in a com-
modity price index the implications for overall
inflation.
Criticisms and qualifications
Some of the features that rTlay make a commodity
price index useful also presentdrawbacks. This is
particularly true of the flexibility of commodity
prices. Being flexible, commodity prices also can
be very volatile. This can be seen in Chart 1. The
thin line traces the annualized monthly growth
rates for a widely-used index ofspot prices, the
Commodity Research Bureau .Index (CRBI). This
index isconstructed using prices for 23 agri-
culturaland industrial commodities, excluding
oil. The heavy linetraces the monthly growth
rates for the CPl.
arbitrage between financial asset and commodity
markets until commodity prices fell to the point
that the expected future capitaLgaim (less stor-
age costs) from holding commodities equaled the
higher return on financial instruments. In other.
words, current prices of commodities would fall
belowtheir expected long-run levels and then
gradually rise....-----.----,-----.--'---'-----1 ·1.00
Fred Furlong
Research Officer
Modest contribution
There is mild empirical support for using a
commodity price index as one of a number of
indicator variables for short-term inflation fore-
casts. However, evidence of the instability in the
relationship between commodity prices and in-
flation means that a commodity price index is not
useful for forecasts of longer-term trends. This,
in turn, argues against using a commodity price
index as a target of policy the way M1 once was
used, or even giving it any special status relative
to other indicator variables.
1.00
0.50
0.00
-0.50
Percentage
Points
1.50
0.05
1988
-0.18
1987 1986
1.06
Chart 3
Inflation Prediction Errors
-0.20
• Standard
Equation
III With
Commodity
Price Index
those from the "standard" inflation equation,
though the contribution of the commodity price
variable can best be described as modest. In par-
ticular, the inclusion of information on past
changes in commodity prices does little to lower
the relatively large inflation forecast error for
1987. Coupled with the VAR results discussed
above, the evidence in Chart 3 indicates that a
commodity price index can be of some use in
short-run inflation forecasts, but such an index is
not a source of information that dramatically
improves our ability to predict inflation.
However, this instability poses less problem in a
short-term forecasting environment. For example,
inclusion of a commodity price index in the VAR
improves somewhat the out-of-sample forecasts
of inflation up to eight quarters ahead.
Moreover, including the commodity price index
in the model's inflation equation reduces the fore-
casting error of the model. As an example of the
contribution the CRBI can make, three separate,
out-of-sample forecasts were made for 1986,
1987, and 1988. These are out-of-sample in the
sense that the inflation equation is reestimated
up to the beginning of each forecast period.
The forecast errors, fourth quarter to fourth
quarter, are shown in Chart 3. The forecast errors
from the equation augmented with the com-
modity price variable are somewhat lower than
Structural model
The contribution of a commodity price index to
short-term inflation forecasts also can be evalu-
ated by incorporating a commodity price index
like the CRBI into a structural macroeconomic
forecasting model such as the one developed·at
this Bank. (For a complete description of this
model, see FRBSF Working Paper 89-01.) In the
model, inflation, measured as the percentage
change in the fixed weight GNP price index, is
explained by past inflation, a measure of slack in
the labor market, changes in real oil prices, and
changes in the real dollar exchange rate. When
this equation is augmented with the lagged
changes in theCRBI that are not related to
lagged values of the other variables in the infla-
tion equation, the changes in the index are
statistically significant in explaining inflation.
The estimate indicates that, on average, an
unexpected 10 percentage-point increase in the
growth rate ofthecommoditypriee index raises
inflation by about 1/2 percentage point over a
period of six quarters.
serious problems for using commodity prices to
predict inflation over a longer-term horizon.
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board. of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.•.. Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.Research Department
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Bank of
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Commodity prices and inflation

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Commodity prices and inflation

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