In the mid-2010s, the global economy witnessed the U.S. dollar gain steam against other major currencies and saw oil prices freefall, along with several other macroeconomic events. Conventional wisdom suggests the health of the U.S. dollar has an inverse relationship to the price of imports and in this case, a strong U.S. dollar decreases the price of imports. However, import prices of consumer discretionary goods don't always move in sync with changes in the U.S. dollar, as foreign firms often choose to maintain its prices in the U.S. market.
Instead, the connection between import prices and the U.S. dollar is reflected by the tendency for commodity prices to fall when the dollar strengthens. The commodity markets are quoted in U.S. dollarsso it may seem intuitive that when the dollar rises, commodity prices will decrease. Simply, a stronger U.S. dollar will impact inflation through commodity prices rather than consumer goods. So, a key factor to consider in anticipating how the currency will affect inflation is the behavior of commodity prices.
Key Takeaways
- Commodities such as precious metals, agriculture goods, and oil & gas have often been touted as a portfolio diversifier that serves as a hedge against inflation.
- While there can be a negative correlation between other asset market prices and that of commodities, commodities tend to respond to changes in the dollar's relative strength in international markets rather than domestic inflation pressures.
- Commodity prices may also respond to particular risk factors such as natural disasters in ways that do not necessarily correspond with inflation more generally.
Unique Shocks
Commodity prices are believed to be a leading indicator of inflation through two basic channels. Leading indicators often exhibit measurable economic changes before the economy as a whole does. One theory suggests commodity prices respond quickly to general economic shocks such as increases in demand.
The second is that changes in prices reflect systemic shocks, such as hurricanes which can decimate the supply of agricultural products and subsequently increase supply costs. By the time it reaches consumers, overall prices would have increased, and inflation would be realized. The strongest case for commodity prices as a leading indicator of expected inflation is that commodities respond quickly to widespread economic shocks.
Pass-Through Effect
In the past, increases in oil prices werebehind a strong increase in the price of goods and services. The reason for thisis that oil is a major input in the economy and is used in critical activities such as heating homes and fueling cars. If the cost of oil increases, then the cost of manufacturing plastics, synthetic materials or chemical products will also rise and be passed onto consumers. This correlation was evident in the 1970sduring the energy crisis.
Weighing the Evidence
Whether its uniqueshocks or general price movements, the commodity-inflation relationship doesn't always hold. For example, an increase in the total demand for final goods and services can coincide with an increase in demand for manufactured goods relative to agricultural products. While this could lead to a rise in overall prices, prices of agricultural commodities might fall.
These types of occurrences suggest that commodity-inflation movements depend on what is driving the commodity change. Moreover, a stronger dollar in the global market will increase the price of commodities relative to foreign currencies. The higher price of commodities in foreign currency will work to lower demand and dollar-priced commodities. In this scenario, increasing commodity prices abroad could cause domestic deflation.
The Bottom Line
The simple two-way relationship between commodity prices and inflation has significantly declined over time. In the 1970s, the relationship was statistically and evidently robust.However, in the past 30 years, the correlation has become less significant. That being said, commodity prices performed well as an indicator of inflation when other factors influencing inflation like employment and exchange rate fluctuations were apparent.
Globalization has increased the interconnectedness of economies, and when commodity prices increase from a strong dollar, this typically results in domestic deflation. While commodity prices are not 100% indicative of inflation, they can be a good starting point when attempting to hedge against inflation.
FAQs
Do commodity prices increase with inflation? Typically, changes in commodity prices can drive inflation trends. According to the U.S. Bureau of Labor Statistics, commodities make up close to 36% of the Consumer Price Index, the most commonly watched inflation measure.
Do commodities have a high correlation with inflation? ›
Because commodities prices typically rise when inflation is accelerating, they offer protection from the effects of inflation. Few assets benefit from rising inflation, particularly unexpected inflation, but commodities usually do.
What is the correlation between inflation and prices? ›
Inflation is the rate of increase in prices over a given period of time. Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country.
Is commodity money affected by inflation? ›
Commodity Money and Inflation
Commodity money has intrinsic value but risks large price fluctuations based on changing commodity prices. If silver coins are used, for instance, a large discovery of silver may cause the value of the silver currency to plunge, resulting in inflation.
What happens when commodity prices increase? ›
An increase in commodity prices can affect the inflation ex- pectations of consumers to a greater extent than price increases of many other goods categories.
How do commodity prices affect economic growth? ›
Theoretically, commodity prices affect a country's income through two channels, “income” and “cost” [8]. Commodity prices determine the value of the commodity and affects the demand for commodities used in agricultural and manufacturing industrial production.
Are commodity prices correlated? ›
A negative correlation between commodity prices and US dollar strength provides non-US economies with a hedge. If the US dollar depreciates when US dollar commodity prices rise, the rise in commodity prices for non-US economies, when measured in local currencies, is smaller.
What do commodities have a high correlation to? ›
Commodities are more correlated to stocks and each other, but not bonds, during bad economic times. Why might the stock-commodity correlation have a business cycle component? There are at least two possible explanations: one based on firm behavior, one based on investor behavior.
Is there a correlation between gas prices and inflation? ›
In the short term. higher inflation tends to lead to higher oil prices. In the longer term, if the Federal Reserve raises interest rates and slows economic growth to control inflation, oil prices could decline as a result.
How does higher prices cause inflation? ›
Inflation can occur when prices rise due to increases in production costs, such as raw materials and wages. A surge in demand for products and services can cause inflation as consumers are willing to pay more for the product.
Price levels are leading indicators in the economy; rising prices indicate higher demand leading to inflation while declining prices indicate lower demand or deflation.
What does inflation correlate with? ›
More jobs and higher wages increase household incomes and lead to a rise in consumer spending, further increasing aggregate demand and the scope for firms to increase the prices of their goods and services. When this happens across a large number of businesses and sectors, this leads to an increase in inflation.
Is there a correlation between inflation and commodity prices? ›
Commodity prices are believed to be a leading indicator of inflation through two basic channels. Leading indicators often exhibit measurable economic changes before the economy as a whole does. One theory suggests commodity prices respond quickly to general economic shocks such as increases in demand.
Do commodities do well in high inflation? ›
Commodities also tend to rally when inflation is boosted by economic growth, and they can provide wealth preservation when central bank credibility declines.
What commodities beat inflation? ›
Gold, Precious Metals, and Commodities
All that glitters is gold, especially during times of inflation. Precious metals such as gold have been historical favorites for hedging against inflation due to their scarcity, tangibility, and historically negative correlation to paper money.
What is the relationship between the US dollar and commodity prices? ›
In commodity price booms, the US dollar typically depreciated. And, when commodity prices fell, the value of the US dollar tended to rise.
How does inflation affect metal prices? ›
Precious metals are a tangible commodity with a limited supply, so their value tends to hold during periods of high inflation as investors turn away from stocks, bonds, and other assets in favour of gold and silver. This pushes up demand, resulting in higher precious metals prices.
What commodities are used to measure inflation? ›
BLS has classified all expenditure items into more than 200 categories, arranged into eight major groups (food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services).
How do commodity prices affect the stock market? ›
One of the main risks is price volatility. Commodity prices can be highly volatile, making it difficult for producers and consumers to plan and budget for their operations. This volatility can also create opportunities for speculators to profit from price movements, which can lead to market distortions.
