Commodity prices and the Fed

I’ve been discussing possible explanations for the recent tendency of the dollar prices of commodities to move together. On Friday we received a very useful data point for distinguishing between the different hypotheses.

Percent change in cash price between Thurs Dec 3 and Mon Dec 7
% change



































One possible explanation for the resurgence of commodity prices since January is the strengthening world economy, particularly outside the United States. But if that is what’s been going on, we should have seen further moves up on Friday, when the U.S. released a key employment report that was far stronger than most of us had anticipated. Whatever you believed about near-term world economic growth on Thursday, on Friday you should have become more optimistic than you’d been on Thursday. But what happened in commodity markets on Friday? The dollar price of almost everything fell quite dramatically.

Others have suggested that
inflation fears
may be part of the commodity price picture. But if inflation expectations are subsiding as a result of a resumption in U.S. employment growth, it would be a very different account of inflation than the kinds of Phillips Curve specifications popular with the Federal Reserve.

Perhaps one could tell an inflation-expectations story based on fears about long-run fiscal solvency. Economic growth is the biggest single factor that could help the U.S. dig out of its deficit hole, and so maybe you’d be a little less concerned about a dollar crisis today than you would have been last week. I note for example this report:

Moody’s is looking at the debt of both the US and UK and does not like what it sees, according to recent data from the credit agency…. The rating of US debt will obviously be based on whether the economy rebounds enough so that the government can cut spending and the size of the national debt no longer grows at break neck speed.

A more natural interpretation of Friday’s commodity price moves would be based on the role of low short-term interest rates in encouraging the commodity price boom. The sooner U.S. employment recovers, the sooner the Fed will start raising interest rates, and the sooner the game of putting borrowed cash into commodities would be up. For example, the implied fed funds rate on the September 2010 futures contract went from 0.5% on Thursday to 0.6% on Friday, consistent with the claim that interest rates have been an important factor in recent commodity price movements.

The Fed is accustomed to thinking of unemployment as the key predictor of inflation, and of relative commodity prices as a separate factor beyond its direct control. I read Friday’s market moves as one more suggestion that commodity price inflation may have more to do with U.S. monetary policy, and less to do with U.S. employment, than many within the Fed are prepared to acknowledge.

28 thoughts on “Commodity prices and the Fed

  1. Dave Backus

    These are, of course, asset prices, and have been studied as such. The language is a little different from yours, but the idea is that developments in financial markets can give them a common component. I’d think of it as cyclical, but maybe that’s too simple. Good examples are
    * Jaime Casassus and Pierre Collin-Dufresne, “Convenience Yields Implied from Interest Rates and Commodity Futures,” Journal of Finance, vol.60, no.5, 2005.
    * Gary B. Gorton and K. Geert Rouwenhorst, “Facts and Fantasies about Commodity Futures,” SSRN, 2005.

  2. Anonymous

    “we received a very useful data point for distinguishing between the different hypotheses”

    Do you do this formally, for example by specifying priors for different economic hypotheses in copula space, or is this a more informal statement?

  3. Tom

    The recent decline in commodity prices and rebound of the dollar were very clearly in step with revised expectations about the course of future monetary policy. Ask anybody involved in the trades and that’s what they’ll tell you. However I’m not sure these traders were right in revising their expectations.

  4. Anonymous

    I’m not so sure about this. The movement in commodity prices since July has been extremely large, in excess of half of the total advance since this time last year. However, in that period the dollar index has declined less than 5%. While the dollar’s decline may be a component of the advance, it certainly does not explain its entirety. In terms of explaining the magnitude of the advance in commodity prices, the dollar index does a poor job.
    I think you need to decompose the move into both fundamental and speculative components. The movement based on dollar factors should probably be considered speculative because, for one thing, it was a relationship that really didn’t exist until recently. However, I think due to the magnitude of the movement there are also fundamental factors at work, which are related to the clearly improved prospects for economic growth compared to March.
    I’ve been watching financial markets for a long time and what moves them from one period to another changes as time goes on. For example, toward the end of an economic expansion, stock markets tend to cheer weaker than expected economic data as they hope for interest rate cuts to prevent an anticipated recession. This rarely happens as the equity markets had hoped, but I’ve seen it twice now (once in late 2000 and once in 2007).

  5. David Pearson

    Your argument has important implications for using NGDP futures targeting as a way to manage monetary policy.
    Following your logic, the weaker RGDP growth expectations, the higher the market will bid up NGDP (on the back of rising inflation expectations). Picture expectations for unemployment rising to 12% in 2010 (which implies roughly 0% RGDP growth). I would expect the market to anticipate future loosening of policy, higher deficits, a falling dollar, and rising commodity AND tradeables prices. NGDP futures would rise rather than fall.
    So an NGDP futures targeting regime would force the Fed to tighten (to lower the NGDP futures price to target) as unemployment rose. Of course, the Fed would do no such thing. It would abandon the regime, and the Fed’s credibility would be severely impaired.

  6. Mark G.

    “A more natural interpretation of Friday’s commodity price moves would be based on the role of low short-term interest rates in encouraging the commodity price boom”
    There is a Chinese saying that one could quench the thirst by drinking poison, Andy Xie

  7. Cedric Regula

    Don’t forget Monday. Ben gave a dovish speech and the dollar headed back down again. Bounced up again Tuesday, and looking for direction today.
    I’m not an economist (have I mentioned that before?), especially not a Fed economist, since I think food and energy prices are headline inflation, but my theory is interest rates are everything, except when they are not.
    Cases of when they are not is when we have boom or bust investor mentality in any asset class. Greenspan himself warned us of irrational exuberance in 1996 and published a simple minded model of stock valuations based on interest rates. But we know how that went. More recently housing went bust, so we have another case were bust wins over interest rate policy.
    I have read somewhere that fiat currency has value for one of two reasons(hopefully two). You can buy stuff with it, or you can lend or invest it and get a return. This seems to sort of work so far.
    But others point out that supply and demand matters, so fundamentals in a market are what is important, not interest rates. Therefore any speculative component of prices has to be temporary, especially in any asset class like hard or soft commodities which need storage, or worse yet, have a useful lifetime.
    Can’t argue with that except that storage has seemed to increase markedly. (China is a storage location, oil tankers are storage, etc….)
    The other part of the puzzle is we have increased easy access to the markets with commodity ETFs. If you believe commodities are an inflation hedge, or if you are really simple minded and believe that a barter economy is the way to go and you may need ownership of pigs and goats to participate in the new economy, you can do a mouse click and put all your funds there.
    There are both targeted commodity ETFs and broad ones, but you can easily take a position in oil and hard commodities ranging from copper to steel, and some soy beans too, without worrying you little head about analyzing fundamentals in all those markets the way the professional smart money is reputed to do.
    And if you think the retail investor can’t move markets, institutional investors do this too.
    I just heard on CNBC that storage costs of oil are now up to $9 a barrel. That is a hidden cost in your oil ETF. Bet you didn’t know that!
    But the paranoid part of my brain really worries that when the Fed stimulates the economy, what we really get in the new, future, moneyless economy is people building oil storage tanks at a breakneck pace, and we will have a private strategic oil reserve along side the government one.
    But it would be jobs, so that part is good.

  8. ppcm

    When glancing through the hereunder thread a slow improvement of lumbers and crushed stones transported is noticeable.The volume is steady since… 1q 2009.
    Money supply (efficient distribution?)
    Market efficiency one day/ 365 ?
    Year end window dressing for commodities funds, equities,bonds?
    The price of the apple in April ?
    Prices incomes revenues lining towards equilibrium?
    Paper profits?

  9. Brian Quinn

    I would be very cautious about picking one day of data to say that this is entirely a monetary phenomenon. Today, for example, the dollar is roughly flat, but gold and oil are posting large declines. Other industrial metals are down too. At the same time, stock prices are rising.
    One needs to study multiple time periods to determine what the actual drivers of the markets are. For example, look at the January through July period and then the July through early December period. See if the same relationships hold. My guess is that they change in character.

  10. RicardoZ

    The Fed is accustomed to thinking of unemployment as the key predictor of inflation, and of relative commodity prices as a separate factor beyond its direct control. I read Friday’s market moves as one more suggestion that commodity price inflation may have more to do with U.S. monetary policy, and less to do with U.S. employment, than many within the Fed are prepared to acknowledge.
    Excellent professor!

  11. AWH

    the unmentioned most important reason why $ commod prices go down when $ goes up; when $ goes up, the commodity price goes up in local currency in all non dollar bloc countries.

    You have probably heard of the rule of higher prices means lower consumption? This is pretty basic global commodity analysis as the markets will anticipate this.

  12. spencer

    If you look at the historic record there is about
    a 62.5% probability that commodity prices rise in the months immediately after the end of a recession.
    Is there really anything very unusual about the rise in commodity prices we are now seeing?

  13. RicardoZ

    Have you ever taken a course in logic?
    It appears that you are making an illogical assumption. I actually would expect commodity prices to rise after almost every recession, but you cannot from this infer that a rise in commodity prices means the end of a recession is near.
    BTW, is the “recession” really over?

  14. Brian Quinn

    Ricardo Z,
    In terms of industrial production, which is probably one of the better indicators to use to determine whether or not economic output is recovering, economic growth around the world has sharply rebounded from the first five to six months of the year. To say that we are not in some form of recovery is very difficult at this point.
    As commodity prices, like most financial asset prices, are based on future expectations as well as present conditions, it makes sense that they would rally in the anticipation of the end of a recession rather than necessarily having to rise immediately following one. They began to rise heavily after the beginning of the year and output seems to have bottomed in June or so.

  15. MarkS

    Excellent post Dr. Hamilton… The speculative inflation of assets, whether stocks or commodities, was enabled by FASB, the treasury and the FED. Subsidy rates for FED funds and subsidy of mortgage securities while banks are reducing their loan portfolios leaves a lot of free cash for punting.
    Nouriel Rubini criticised tier one banks for increasing their value at risk with equity purchases in April 2009. It was only a matter of time for commodities to follow.

  16. Doc at the Radar Station

    “The sooner U.S. employment recovers, the sooner the Fed will start raising interest rates, and the sooner the game of putting borrowed cash into commodities would be up.”
    YES, you hit the nail on the head here. I’ve got a pet theory of mine that when interest rates are between 0% and the target inflation rate – say 2% – you get this “casino effect” that has deleterious consequences that subtract from any positive effect of reducing “real” interest rates. Yes, yes, they are propping up banks with a “fat spread”, but if this is forming commodity bubbles and thus reducing disposable income and aggregate consumer demand, what good is it doing?

  17. Mattyoung

    I have oil imports approaching their 2001 levels when oil first became overly constrained. The price then, $30/barrel, today $75, or a 10% annual inflation. Core CPI is now, near 0%. So, the financial community has managed to boost the oil price and gain some wiggle room.
    I guess finance had to defeat the Taylor rule to fix oil, right? Isn’t that what Jim is saying here, that Uncle Milt was wrong about inflation, it is not a monetary phenomena, it is a relative constraint phenomena.
    Gail the Actuary presents an etiology of the crisis from the perspective of volatile oil since 2000, interesting read.
    By the by, I think Ben does get this problem, now.

  18. aaron

    Might also have to do with the weather. I believe we were expecting a very mild winter in the US. That seems to have changed, natural gas is up 8% today.
    A harsh winter would hinder our recovery, driving down demand for oil for non-heating purposes. Oil is finally below 70, where it needs to stay if there’s going to any meaningful recovery. But it might only be there because we’re now expecting people to spend several months holed-up.

  19. mike

    These are very good points. I’ve been skeptical about the dollar and interest rates links being a major driver of commodity price fluctuations but you’re starting to convince me.
    So, I think you’re saying the arrow of causality goes as follows: (1) more optimism about U.S. Economy, which leads to (2) expectations that the Fed will raise short-term interest rates, which leads to (3a) lower commodity prices through basic storage/intertemporal arbitrage AND (3b) an increase in the value of the dollar.
    So we see associations tight associations between the dollar and commodity prices these days because both are heavily influenced by the common underlying factor that is expectations about the Fed expectations (which are pretty uncertain at the moment).

  20. Cedric Regula

    Depth and liquidity of markets is always worth something. Come to think of it, there is no other reason to own T-bills at the moment.
    Jim Rogers was on CNBC today. He’s always entertaining, and as usual advised us all to get into farming.
    But this got me thinking again of what should we do as far as coming up with the new economy we need to replace the old one that broke.
    Why not combine the best of the Agricultural Age, Information Age and Financial Age into one robust economy?
    Have Jim Rogers launch the Pigs&Goats ETF, partner with Ebay, launch the PayPal Corral(tm)where PayPal customers will keep their ETF, and settle Ebay and other transactions in pigs and/or goats.
    Rogers says we don’t need the Fed for anything, and I believe I’m starting to see the light.

  21. aaron

    If stock markets are moving up as oil, etc. move down, as Brian Quinn suggest, that suggests people moving out of these in expectation of improvement and higher rates rather than decreased demand.

  22. Anonymous

    Perhaps you may find these papers useful on the question of commodity prices, exchange rates, & inflation.

    Abbott, Hurt, and Tyner (2008). “What’s Driving Food Prices?” Issue report, Farm Foundation, Oak Brook, IL.

    Abbott, Hurt, and Tyner (2009). “What’s Driving Food Prices? March 2009 Update.” Issue report, Farm Foundation, Oak Brook, IL.

    Both are available at:

  23. rookie_parisian

    Tom : thanks for that short insider’s comment that makes a lot of sense to me.
    For example, Gold at 1200$ is trading at 3 times its average marginal cost of production. Buying at that price means that a/ you think there will be greater fools b/ you believe in the hyperinflation scam “a la Rogers”. I hope that almost everyone on this blog falls in the a/ category.
    Good employment numbers means that the end of free money is approaching faster than the market anticipated. It’s time to sell near the top all your leveraged positions, take the money and run, and look for the next bubble.

  24. bigsky

    The grain trade watches the dollar like a hawk and has for years. We see the overseas buyers backing off when the dollar rallies on a daily basis. Futures markets are discounting mechanisms. As relevant, comparative, competitve trends wrestle for influence they are reflected in the trades. Inflation expectations translated into the value of the dollar have immediate and long term effects through the futures markets on their respective commodities.

  25. Cedric Regula

    As soon as we find correlation, the rules of the game change. Got a new data point last night. S&P downgraded Greece yesterday and the buck went up 1% overnight.
    I see the potential for a new sort of “strong dollar policy”. US rating agencies will dole out downgrades on all the weaker sovereign debt out there.
    GS thinks the Euro goes to 1.35.

  26. Paco Ahlgren

    Great article that pays attention to monetary policy!
    The world is in a lot of trouble right now, but our greatest enemies aren’t inflation and unemployment. The most alarming issues before us are ignorance and apathy.
    Increasing asset prices are not a good indicator that conditions are improving. Conditions, for the most part, won’t be improving, because increases in the prices of most assets — including the stock market — won’t outpace collapsing global currencies.
    Commodities, agriculture, and precious metals are always the best indicators of coming inflation. I’ve pointed out in several recent articles that gold was at $250 an ounce the first time the Dow crossed 10,000.
    SeekingAlpha Paco Ahlgren
    There’s no way that metals can’t go higher with the amount of currency being printed, and the unprecedented easing of credit we’re seeing around the world.
    I also believe agriculture and energy are going to outpace inflationary price increases for a very long time.

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