Can Exchange Rates Forecast Commodity Prices?

Abstract

This paper demonstrates that “commodity currency” exchange rates have remarkably robust power in predicting future global commodity prices, both in-sample and out-of-sample. A critical element of our in-sample approach is to allow for structural breaks, endemic to empirical exchange rate models, by implementing the approach of Rossi (2005b). Aside from its practical implications, our forecasting results provide perhaps the most convincing evidence to date that the exchange rate depends on the present value of identifiable exogenous fundamentals. We also find that the reverse relationship holds; that is, that commodity prices Granger-cause exchange rates. However, consistent with the vast post-Meese-Rogoff (1983a,b) literature on forecasting exchange rates, we find that the reverse forecasting regression does not survive out-of-sample testing. We argue, however, that it is quite plausible that exchange rates will be better predictors of exogenous commodity prices than vice-versa, because the exchange rate is fundamentally forward looking. Therefore, following Campbell and Shiller (1987) and Engel and West (2005), the exchange rate is likely to embody important information about future commodity price movements well beyond what econometricians can capture with simple time series models. In contrast, prices for most commodities are extremely sensitive to small shocks to current demand and supply, and are therefore likely to be less forward looking. J.E.L. Codes: C52, C53, F31, F47. Key words: Exchange rates, forecasting, commodity prices, random walk. Acknowledgements. We would like to thank C. Burnside, C. Engel, M. McCracken, R. Startz, V. Stavreklava, A. Tarozzi, M. Yogo and seminar participants at the University of Washington for comments. We are also grateful to various staff members of the Reserve Bank of Australia, the Bank of Canada, the Reserve Bank of New Zealand, and the IMF for helpful discussions and for providing some of the data used in this paper.