Why Commodity Prices May Have Peaked

 Among the most salient of economic developments in the last two years have been big movements in the prices of oil, minerals, and agricultural commodities.  It was hard to miss the big rise in commodity prices.  The Brent oil price increased from a low $20 a barrel in April 2020, during the first Covid-19 wave, to a peak of $122, in March 2022, after Russia invaded Ukraine.  But it was not just oil. The price of copper doubled over this period.  Wheat more than doubled. And so on. Global indices of commodity prices almost tripled from April 2020 to March 2022.

These figures are in dollars.  Prices rose even more when viewed in terms of euros, yen, won, or other currencies.

Not quite as widely observed is that prices of many commodities fell somewhat over the summer. The price of oil decreased by about 30 percent between early June and mid-August.  The politically sensitive American price of gasoline also has fallen 20 percent since June, from $5/gallon to $4 in mid-August.  The overall CRB index has fallen 12 percent as of August 17

Is this dip in commodity prices just temporary? Or is it a sign that they have peaked and can be expected to fall further in the future?

1. Why are prices of different commodities so correlated?

Mostly, the prices of different commodities are highly correlated.  In many cases, this is due to direct microeconomic linkages.  When the price of oil rises, the costs to wheat producers rise, because harvesting equipment runs on diesel while fertilizer is made from natural gas, which puts upward pressure on grain prices.  But the correlation across widely disparate energy, mineral and agricultural commodities begs for a macroeconomic explanation.

There are two macroeconomic reasons to think that commodity prices in general will fall further. One of them is self-evident, the other less so.

Different stories apply to different commodities, of course, due to microeconomic particulars. The price of natural gas in Europe is bound to rise, as the continent learns to manage winter without Russian gas. But the story is likely to be different elsewhere.

2. Global growth

The most obvious macroeconomic factor is the overall level of economic activity.  GDP is an important determinant of the demand for commodities and therefore their real price.  Less obviously, the real interest rate is another determinant.  As of now, the outlook for world growth (slowing) and the outlook for interest rates (upward) both suggest a downward path for commodity prices.

Strong global growth, especially in China, can explain the major upswings of commodity prices in 2004-07, 2010-11, and 2021.  Conversely, abrupt recessions can explain the plunge in commodity prices from June 2008 to February 2009 (during the Great Recession), and again from January to April 2020 (in the pandemic recession).  This leaves unexplained, for the moment, the spike in commodity prices in the first half of 2008 and the decline in 2014-15.

Global growth is currently slowing, for well-known reasons.  China’s growth rate has faltered dramatically (particularly in the commodity-intensive manufacturing sector). It actually turned negative in the second quarter, as Shanghai and some other cities endured shutdowns in support of a futile zero-Covid policy. Europe is hard-hit by the side effects of the Russian invasion of Ukraine.  Even US growth is slower in 2022 than it was last year, with many proclaiming that a recession has begun. (Personally, however, I am still willing to bet that no US recession started in the first part of the year and that either first-quarter or second-quarter GDP will be revised upward by end-September.)

Overall, according to the IMF’s most recent World Economic Outlook update, global growth is projected to slow substantially, from 6.1 % in 2021, to 3.2 % in 2022 and 2.9 % in 2023.  Slowing growth means lower demand for commodities, and hence lower prices.

3. Real interest rates

In addition, as the Fed and other central banks tighten monetary policy, real interest rates are expected to rise.  This is likely to lower commodity prices, and not just because high real interest rates make a recession more likely.  Interest rates have an effect independently of GDP, both in theory and statistically.

The theory of the relationship between interest rates and commodity prices is long-established.  I like the “overshooting” formulation of the theory.  The simplest intuition behind the relationship is that the interest rate is a “cost of carrying” inventories.  A rise in the interest rate reduces firms’ demand for holding inventories and therefore reduces the commodity price.

Three other mechanisms operate, in addition to inventories.  First, for an exhaustible resource, an increase in the interest rate increases the incentive to extract today, rather than leaving deposits in the ground for tomorrow.   Second, for commodities that have been “financialized,” an increase in the interest rate encourages institutional investors to shift out of the commodities asset class and into treasury bills.  Third, for a commodity that is internationally traded, an increase in the domestic real interest rate may cause a real appreciation of the domestic currency, which works to lower the domestic-currency price of the commodity.

The relationship between real interest rates and commodity prices is also established statistically, by econometric analyses that range from:
(i) simple correlations; to
(ii) regressions that control for other important determinants, such as GDP and inventories in a “carry trade” model; to
(iii) high-frequency event studies, which are much less sensitive to the econometric problems of the regressions, namely issues of causality and time series properties.

Two episodes illustrate the claim that the effect of monetary policy operates independently of the effect of GDP.  Neither the spike in dollar commodity prices in the first half of 2008 nor the decline in 2014-15 can be explained by fluctuations in economic activity; but they can be interpreted as the result of easy US monetary policy (QE) and tightening US monetary policy (the end of QE), respectively.

Real interest rates currently appear to be on a firm upward trend, both because nominal interest rates will rise and because inflation will fall.  That could mean that real prices of oil, minerals, and agricultural products are on their way down.