Academic journal article Economic Inquiry

An Examination of Linear and Nonlinear Causal Relationships between Commodity Prices and U.S. Inflation

Academic journal article Economic Inquiry

An Examination of Linear and Nonlinear Causal Relationships between Commodity Prices and U.S. Inflation

Article excerpt

I. INTRODUCTION

There is considerable literature on the use of commodity price information (particularly oil prices) in predicting economic activity and inflation. This, in large part, reflects the view that higher commodity prices, such as oil prices, in particular, tend to be followed by inflation and recessions (Barksy and Kilian 2002, 2004; Hamilton 2003). While much of the literature has focused on the oil price-macroeconomy relationship, policymakers and economists, for a long time, have been interested in the commodity-consumer price nexus, and increasingly so with the rise in inflation targeting as part of an objective of monetary policy. (1)

More recently, the inflation experience of the 2000s before the global financial crisis was attributed to rising prices for globally traded commodities. This event has generated a renewed interest on inflationary consequences of commodity prices despite considerable debate on the usefulness of commodity prices as a leading indicator for inflation. (2)

This study empirically examines the relationship between changes in commodity prices and inflation. Its contributions are fourfold. Firstly, we investigate the performance of a variety of commodity price indices as standalone indicators of inflation. We consider a myriad of Commodity Research Bureau (CRB) grouping indices including, among others, metals, raw industrials, textiles and fibers, livestock and products, and a composite index comprising all grouping indices. One reason for this is that by lumping together a diverse group of commodities, the indices could obscure their components' predictive power. This would be the case if some commodities were not good inflation predictors or if the timing of the inflation signals varied among different kinds of commodities. The results, by and large, indicate that the empirical link between commodity prices and inflation has changed dramatically over time, partly because of the changes in the extent to which movements in commodity prices reflect idiosyncratic shocks, and partly due to the change in macroeconomic fundamentals such as low inflation and lower uncertainty about future inflation and output growth that prevailed during the period of Great Moderation. Secondly, this article demonstrates that there is significant evidence of nonlinear causality between inflation and changes in metal and raw industrial price indices during the Great Moderation, even though this nonlinear causal relationship was absent prior to that period. As for other commodity price changes and inflation the degree of linear causal relationship has changed, albeit moderately, during the Great Moderation, supporting earlier studies of Whitt (1988), Furlong (1989), and Blomberg and Harris (1995). Thirdly, we show evidence that the nonlinear relationship is due primarily to the rate of information flow which occurs during periods of high volatility in these commodity prices in late 2000. This suggests that the widely documented linear relationship is more complex than initially thought. The existing research on the nature and sources of causal relationship between commodity prices and inflation has, to date, focused relatively on a linear causal relationship and has ignored the possibility of nonlinear causal relationship. This is surprising and indicates an important gap in this line of research given a priori that economic theory does not predicate a linear functional form for the relationship between changes in commodity prices and inflation.

Finally, on the methodology front, this study employs a robust approach for testing the presence of nonlinear causal relationship between commodity prices and inflation. One potential concern is that the nonlinear causality inferred from the Baek and Brock (1992) test may be affected by the presence of linear relations in the data. (3) For this reason, we fitted a vector autoregression (VAR) model to the data and apply the modified Baek and Brock test for Granger non-causality to the resulting residuals. …

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