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 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.
How do commodity prices affect economic growth? ›
Inflation: Rising commodity prices can lead to higher inflation as producers pass on the increased costs to consumers. This can cause prices for goods and services to rise, reducing the purchasing power of consumers and leading to lower economic growth.
What commodities are used to measure inflation? ›
The Consumer Price Index (CPI) measures inflation by tracking the changes in prices paid by consumers for a basket of goods and services over time. These goods and services include food and beverages, housing, apparel, transportation, medical care, recreation, education, and communication.
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.
What are the best commodities for inflation? ›
Many investments have been historically viewed as hedges—or protection—against inflation. These include real estate, commodities, and certain types of stocks and bonds. Commodities include raw materials and agricultural products like oil, copper, cotton, soybeans, and orange juice.
What correlates with commodities? ›
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.
What is the relationship between price level and inflation? ›
Price levels are leading indicators in the economy; rising prices indicate higher demand leading to inflation while declining prices indicate lower demand or deflation.
This increase in aggregate demand puts pressure on domestic production capacity, and increases the scope for domestic firms to raise their prices. These price increases contribute indirectly to inflation through the demand-pull channel.
What does inflation correlate with? ›
Inflation Lifts Growth & Employment in the Short Term
Elevated inflation discourages saving because it erodes the purchasing power of savings over time. That prospect can encourage consumers to spend and businesses to invest. Unemployment often declines at first as inflation climbs as a result.
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.
What causes commodity prices to rise? ›
Just like equity securities, commodity prices are primarily determined by the forces of supply and demand in the market. For example, if the supply of oil increases, the price of one barrel decreases. Conversely, if demand for oil increases (which often happens during the summer), the price rises.
What happens when commodity prices fall? ›
Lower commodity prices are a risk for commodity producers. If crop prices are high this year, a farmer may plant more of that crop on less productive land. If prices fall next year, the farmer may lose money on the additional harvest planted on less fertile soil. This, too, is a type of commodity price risk.
How do you trade commodities during inflation? ›
When inflation goes up, you can buy gold, but you won't necessarily take ownership of the physical commodity to get exposure. With us you'll trade spot gold, futures or options on the gold price directly. Or you can trade or invest in gold ETFs or ETCs, or stocks in gold mining or producing companies.
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.
What does a rise in the price of a commodity mean? ›
Commodity prices typically rise when inflation accelerates, which is why investors often flock to them for their protection during times of increased inflation—particularly unexpected inflation.
