"Effects of Speculation and Interest Rates in a “Carry Trade” Model of Commodity Prices," 2014, Journal of International Money and Finance, vol.42, pp. 88-112. HKS RWP13-022; NBER WP 19463.
Stata fies (data, do & log), thanks to Marco Martinez, June 2013 (excludes proprietary Consensus Economics data).
Video of session on forecasting commodity prices, conference on Understanding International Commodity Price Fluctuations (organized by the IMF Research Dept. & the Oxford Centre for the Analysis of Resource Rich Economies, March 2013, Washington, D.C.)
"Determination of Agricultural and Mineral Commodity Prices," with Andrew Rose, Chapter 1 in Inflation in an Era of Relative Price Shocks (Reserve Bank of Australia: Sydney), 2010: pp. 9-51. Data. HKS RWP 10-038.
"The Effect of Monetary Policy on Real Commodity Prices", Chapter 7 in Asset Prices and Monetary Policy, John Campbell, ed. (U.Chicago Press), 2008: 291-327. NBER WP 12713.
"Commodity Prices, Money Surprises, and Fed Credibility," with Gikas Hardouvelis, 1985, Journal of Money, Credit and Banking 17, no. 4, November, Part I, 427-438. NBER WP 1121, 1983. Reprinted in J.Frankel, Financial Markets and Monetary Policy, 1995.
A way of isolating monetary effects on commodity prices is to look at jumps in financial market prices that occur in immediate response to government announcements that change perceptions of monetary policy, as was true of Fed money supply announcements in the early 1980s. Money announcements that caused interest rates to jump up would on average cause commodity prices to fall, and vice versa.
The central claim of this research:
Real interest rates are an important influence on real prices of oil, minerals, and agricultural commodities. The argument is summarized briefly in "Monetary Policy and Commodity Prices," VoxEU, May 2008; and "An Explanation for Soaring Commodity Prices," VoxEU, March 2008.
Other factors matter too of course. One way to control for other factors is to employ measures of convenience yield and risk in the equation that determines inventory holdings. My later papers on the subject use those variables, along with inventories, to determine commodity prices:
The mechanisms:
High interest rates reduce the price of storable commodities through four channels:
¤ by increasing the incentive for extraction today rather than tomorrow (think of the rates at which oil is pumped, gold mined, forests logged, or livestock herds culled)
¤ by decreasing firms' desire to carry inventories (think of oil inventories held in tanks)
¤ by encouraging speculators to shift out of commodity contracts, and into treasury bills (think of "financialization," which has made commodities into an asset class)
¤ by appreciating the domestic currency and so reducing the price of internationally traded commodities in domestic terms, even if the price hasn't fallen in terms of foreign currency.
All four mechanisms work to reduce the real market price of commodities, as happened when real interest rates where high in the early 1980s. A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories, and raising commodity prices.
The overshooting theory
The theoretical model can be summarized as follows. A monetary contraction temporarily raises the real interest rate (whether via a rise in the nominal interest rate, a fall in expected inflation, or both). Real commodity prices fall. How far? Until commodities are widely considered "undervalued" -- so undervalued that there is an expectation of future appreciation that is sufficient (together with other advantages of holding inventories, namely the "convenience yield") to offset the higher interest rate (and other costs of carrying inventories: storage costs plus any risk premium). Only then are firms willing to hold the inventories despite the high carrying cost. In the long run, the general price level adjusts to the change in the money supply. As a result, the real money supply, real interest rate, and real commodity price eventually return to where they were.
The theory is the same as Rudiger Dornbusch's famous theory of exchange rate overshooting, with the price of commodities substituted for the price of foreign exchange.
See: "Expectations and Commodity Price Dynamics: The Overshooting Model," American Journal of Agricultural Economics 68, no. 2, May 1986, 344-348. Reprinted in Frankel, Financial Markets and Monetary Policy, MIT Press, 1995.
The deep reason for the overshooting phenomenon is that agricultural and mineral prices adjust instantly, while most other prices adjust slowly.
See: "Commodity Prices and Money: Lessons from International Finance," American J. of Agricultural Economics 66, no. 5, Dec. 1984, 560-66.
Of course many other things beyond real interest rates and growth influence commodity prices. One can try to control for some variables, such as global economic activity and uncertainty, as in the 2010 and 2013 papers.
Simple graphs of real commodity price index versus short-term real interest rate.
Real commodity prices (in $) have been negatively correlated with the real 3-month T-bill rate.
(Thanks to Marco Martinez.)
The relationship is statistically significant. Regression results for 1950-2012 are available in Frankel (2013), as are tests with alternative indices from CRB, Dow Jones, Reuters & Goldman Sachs, thanks to R.A. Marco Martinez del Angel. All these results are still significant in regression results updated to 2018, Frankel & Martinez (pdf).
