Are commodity prices a good leading indicator of general price inflation?
According to several different measures, commodity prices have been declining
since mid- to late-1996. Some analysts have argued that this foreshadows
further declines in inflation in the U.S. However, the links from commodity
prices to overall inflation are tenuous.
The strongest case for commodity prices as an indicator of future inflation
is when economy-wide demand shocks are important, such as when there is
a change in monetary policy. Commodity prices often are set in competitive
auction markets and are more flexible than overall prices. Therefore,
an economy-wide increase in demand, for example, would tend to raise commodity
prices before other prices begin to rise. Changes in the supply of important
commodities also can be expected to show up in commodity prices before
they show up in overall prices. The oil shocks of the 1970s are good examples,
when increases in oil prices were followed by increases in overall inflation.
However, shifts in the relative demand for commodities and goods
tend to "muddy the waters" because a change in the demand for commodities
relative to manufactured goods would lead commodities and goods prices
to move in opposite directions. For example, an increase in the demand
for manufactured goods relative to agricultural products could lead to
a rise in overall inflation but a decline in commodity prices.
Therefore, the usefulness of commodity prices as indicators of future
inflation depends upon the importance of these various channels at any
particular time. It is not surprising that empirical analysis suggests
that the relationship between commodity prices and inflation tends to
change over time. For example, some studies have found that commodity
prices were useful indicators in the 1970s and the first part of the 1980s,
but have been less so since then. While commodity prices provide some
useful information in forecasting inflation, especially when used in conjunction
with other factors that influence inflation, it is questionable whether
they are reliable enough to be used as the primary source of inflation
For Further Reading
Furlong, Fred and Robert Ingenito. 1996. "Commodity
Prices and Inflation." Federal Reserve Bank of San Francisco
Economic Review, Number 2, pp. 27-47.