Saturday, April 29, 2017

New York Fed: The Information Value of Commodity Prices

From the Federal Reserve Bank of New York's Liberty Street Economics blog, March 21, 2016:

What Tracks Commodity Prices?
Various news reports have asserted that the slowdown in China was a key factor driving down commodity prices in 2015. It is true that China’s growth eased last year and, owing to its manufacturing-intensive economy, that slackening could reasonably have had repercussions for commodity prices. Still, growth in Japan and Europe accelerated in 2015, with the net result that global growth was fairly steady last year, casting doubt on the China slowdown explanation. An alternative story relies on the strong correlation between the dollar and commodity prices over time. A simple regression shows that both global growth and the dollar track commodity prices, and in this framework, it is the rise of the dollar that captures last year’s drop in commodity prices. Thus a forecast of stable global growth and a relatively unchanged dollar suggests little change in commodity prices in 2016. 

Prices Are Correlated with Global Growth
Commodity prices tend to fall when the global economy falters and rise when it is booming. The chart below compares global growth, as measured by the International Monetary Fund, with the annual percentage change in the Commodity Research Bureau price index for raw industrial goods (various metals, cotton, rubber, wool, and other goods). The two lines move together, with a regression using global growth having an R-squared of .52. That is, global growth explains around 50 percent of change in this commodity price index over this period. Looking at the chart, the closest co-movements are from 2004 to 2007—when the world economy was growing at an annual pace of more than 5 percent and the commodity price index was rising 15 percent per year—the collapse in growth in 2008-09, and the rebound in 2010-11. However, this relationship struggles to explain the 1995-96 and 2012-15 periods, with the latter being one of stable global growth and steep commodity price declines in both 2012 and 2015.
The stability of global growth does not necessarily preclude China’s flagging growth from having a significant role in the decline of commodity prices last year. In particular, China is more commodity-intensive than Japan and Europe and this shift in composition of growth last year is hidden in the global growth variable. Breaking down global growth into emerging and advanced countries reveals that the volatility of commodity prices is better captured by the growth of emerging economies than the growth of advanced economies. Some of this may be due to commodity prices affecting the economies of commodity-producing countries. Still, growth in emerging economies only slowed by half of a percentage point in 2015, so this variable is not enough to explain last year’s steep decline. Also, note that a regression using global growth does a better job tracking commodity prices than one that relies only on the growth of emerging economies.

Prices Are Also Correlated with the Dollar
Analysts looking for another explanation of last year’s price decline point to the strong correlation of commodity prices with the dollar—commodity prices tend to fall (rise) when the dollar appreciates (depreciates). One theory is that prices fall when the dollar strengthens because commodities priced in dollars become more expensive to the rest of the world, thereby restraining demand. It is a plausible explanation, but it is also quite possible that the dollar is not a causal factor and is instead correlated with other underlying factors affecting commodity prices.

The next chart shows these two data series with the dollar index of major currencies inverted so that the relationship is easier to see....MUCH MORE