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 forecasts.
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.