Tracking core commodity price inflation concerns some

By Paul Kupiec

While pundits argue whether April’s reading on US consumer price inflation is a harbinger of future inflation or merely a transitory statistical anomaly, global commodity prices are marching higher. It’s not just the price of lumber or gasoline — the data suggest that there has been positive momentum in the prices of a whole host of globally traded commodities.

The prices of all traded goods and services can rise and fall for many reasons. Weak demand caused by slow growth or recessions can temporarily depress prices. Technological breakthroughs can increase productivity and reduce costs, resulting in more durable price declines. Similarly, strong demand and shocks that limit output and increase production costs can cause prices to rise. These textbook causes of positive and negative price changes are constantly impacting markets for globally traded commodities.

Central bank monetary policies can also impact global commodity prices. If a major central bank implements a stimulative monetary policy, its impact on domestic demand could trigger an increase in demand for commodities that impacts global prices. If several major central banks simultaneously adopt stimulative monetary policies, the potential impact on global commodity demand will be magnified, potentially creating upward pressure on global commodity prices. Price pressures will be commensurately greater if the supply of commodities is restricted by events with a widespread impact, like a global pandemic.

The prices of globally traded commodities vary over time. The impetus causing a commodity price to change may be idiosyncratic to a single commodity, or it may simultaneously impact several commodity prices. Among the factors impacting commodity prices, the impact of inflationary or deflationary monetary policy is unique. Unlike shocks that change the relative prices of commodities, an inflationary or deflationary monetary policy will impact all commodity prices simultaneously and identically. Identically means in the same direction and by an identical percentage-change magnitude.

Given enough time series data on a large cross-section of commodity prices, it is possible to extract a reasonable estimate of the magnitude of the common inflationary or deflationary stimulus simultaneously impacting all commodity prices in a given month. I use monthly data on the prices of 63 globally-traded commodities as reported by the International Monetary Fund (IMF) to extract an estimate of the common inflation component impounded in monthly commodity price changes when prices are quoted in US dollars, and price changes are measured in percent. The monthly inflation estimates extracted from commodity prices are reported in the following chart.

Note: Commodity returns are modeled as a linear combination of a common factor that simultaneously impacts all commodity prices by the same percentage amount in each month as well as additional factors that impact prices but are idiosyncratic to only one commodity, or at most a few commodities simultaneously. Under these assumptions, the monthly time effect coefficients in a linear regression model are estimates of the common inflation factor. Generalized least squares is used to correct for commodity-specific heteroscedasticity.

Besides the recent spike in commodity price inflation that has occurred against the backdrop of the unprecedented global monetary stimulus response to the global COVID-19 pandemic, there are at least two other interesting features of this chart. The first is that the estimated inflation component is always positive. This means that the overall impact of global monetary policies on commodity prices is always inflationary.

There is nothing in the statistical estimation technique that prevents the common component from being negative in some months, but it is never negative, at least in this sample period. So the impact of global monetary policies on commodity prices is never transitory. It only pushes prices in one direction — up.

The other interesting feature of the chart is the clear identification of the period immediately preceding the financial crisis as an episode of rapid commodity price inflation. In mid-2008, before the crash, both the Federal Reserve and the IMF issued reports commenting on the potential importance of rapidly rising commodity prices. The Federal Reserve attributed commodity price increases to strong demand from emerging market economies and to various transitory factors restricting supply. The IMF report largely echoed the Fed report as to the causes, but expressed more concern that commodity price inflation could trigger consumer price inflation and impact investor inflation expectations. In a few short months, the onset of the financial crisis erased any concerns about inflation.

Will the current spike in commodity price inflation trigger consumer price inflation and cause investors to reevaluate their expectations?