Commodities are Probably a Bad Way to Track Inflation
US President Trump’s nominee for Federal Reserve Board of Governors, Stephen Moore, was on Bloomberg this morning touting his unconventional ideas on monetary policy. During the interview, he suggested the Philip’s Curve was broken (it somewhat is) and that instead the Federal Reserve should focus on the relationship between inflation expectations and commodities, a pitch that inevitably leads down the path towards the reintegration of the gold standard.
This begs the question though, is there a relationship between inflation and commodities? It’s difficult to say since we do not have precise data, however we do have data on inflation expectations. Moreover, we can use the Western Asset Inflation ETF as a proxy which is a derivative of various inflation-tied assets such as inflation-linked treasury bonds in the US, a strong correlative with expected inflation. We can see that Moore is somewhat correct in his notion when it comes to gold, oil, and soybeans.
However, there is a problem with this idea primarily that commodity prices can dramatically fluctuate on a weekly basis whereas consumer inflation (the primary measurement of inflation) does not. While expected inflation tends to be correlated with actual inflation, it is difficult to determine which commodities we should use to track inflation. The best which come to mind are obviously oil and gold, but beyond those two staple commodities its less clear. Soybeans are a good candidate, but perhaps we are suffering from confirmation bias since the correlation seems to be tight.
What about lumber, sugar, or natural gas? Are these not commonly used commodities which could be used as proxies for price increases? Yes, but adding those to the mix significantly muddies this commodities-based approach and these are two commonly used commodities.
Volatility is extremely high in these markets as can be seen with sugar spiking in 2016, lumber spiking in early 2018 and natural gas spiking in late 2018. This brings us to the crux of another problem with the commodities-based inflation relationship; just because prices increase on the market does not mean that prices are transferred to the consumer. This concept is called pass-through and the IMF found that very little pass-through occurs during commodity price shocks to the consumer meaning that you cannot actually use commodity prices as a proxy for actual inflation.
The bottom line is that macroeconomics is quite complex. The Philip’s Curve and its counterpart the Augmented Philip’s Curve worked for a long time until they didn’t. Clearly, economists need to develop a better theory on what drives inflation. However, commodity prices are not that explanation. Time to keep looking.
This begs the question though, is there a relationship between inflation and commodities? It’s difficult to say since we do not have precise data, however we do have data on inflation expectations. Moreover, we can use the Western Asset Inflation ETF as a proxy which is a derivative of various inflation-tied assets such as inflation-linked treasury bonds in the US, a strong correlative with expected inflation. We can see that Moore is somewhat correct in his notion when it comes to gold, oil, and soybeans.
However, there is a problem with this idea primarily that commodity prices can dramatically fluctuate on a weekly basis whereas consumer inflation (the primary measurement of inflation) does not. While expected inflation tends to be correlated with actual inflation, it is difficult to determine which commodities we should use to track inflation. The best which come to mind are obviously oil and gold, but beyond those two staple commodities its less clear. Soybeans are a good candidate, but perhaps we are suffering from confirmation bias since the correlation seems to be tight.
What about lumber, sugar, or natural gas? Are these not commonly used commodities which could be used as proxies for price increases? Yes, but adding those to the mix significantly muddies this commodities-based approach and these are two commonly used commodities.
Volatility is extremely high in these markets as can be seen with sugar spiking in 2016, lumber spiking in early 2018 and natural gas spiking in late 2018. This brings us to the crux of another problem with the commodities-based inflation relationship; just because prices increase on the market does not mean that prices are transferred to the consumer. This concept is called pass-through and the IMF found that very little pass-through occurs during commodity price shocks to the consumer meaning that you cannot actually use commodity prices as a proxy for actual inflation.
The bottom line is that macroeconomics is quite complex. The Philip’s Curve and its counterpart the Augmented Philip’s Curve worked for a long time until they didn’t. Clearly, economists need to develop a better theory on what drives inflation. However, commodity prices are not that explanation. Time to keep looking.
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