Academic journal article Chicago Fed Letter

The Ups and Downs of Commodity Price Indexes

Academic journal article Chicago Fed Letter

The Ups and Downs of Commodity Price Indexes

Article excerpt

The ups and downs of commodity price indexes

The current concern about inflation began with the run-up in commodity prices at the beginning of 1993. At that time, financial markets overreacted when they interpreted a temporary surge in commodity price indexes as a sign of imminent higher inflation. As it turned out, commodity prices were responding to a variety of short-lived economic events and, contrary to expectation, inflation actually declined in 1993.

More recently, the robust growth in domestic economic activity since late 1993 has caused some pressure on the prices of some industrial materials. As a result, the spotlight is once again on commodity price indexes as leading indicators of inflation. Commodity-based indicators are calculated as an average of the prices of different commodities, and potentially translate individual price movements into a common measure of aggregate price changes.

Spot and futures prices of individual commodities are determined and quoted daily in competitive auction markets; these prices adjust quickly to changes in supply and demand. Commodities account for only a small fraction of the cost of finished goods. Yet because they have a considerable weight in Consumer Price Index (CPI) calculations, a continued increase in commodity prices may push up the inflation rate, as measured by the percent change in the CPI. Thus changes in materials prices can be real-time indicators of other price changes, current or anticipated.

A considerable amount of time may pass, however, before commodity price gains translate into higher inflation. Furthermore, price increases in industrial commodities and raw materials don't always cause inflation to rise. Sometimes they are only temporary responses to a variety of events whose effects reach no further. Also, since commodity price indexes respond to changes in supply and demand of individual commodities, they may reflect price fluctuations that are only relative and not indicative of inflationary pressures.

The November 1993 Chicago Fed Letter showed that inflation forecasts based on individual commodity prices and commodity price indexes can be highly misleading, since commodity prices often signal concurrent changes in price and output.(1) In this Fed Letter we take the analysis a step further and present evidence that commodity price indexes are not statistically useful in predicting consumer price inflation. First, we analyze the compositional characteristics of three different commodity price indexes designed specially to help forecast inflation. Then we present the results of a number of statistical tests we performed to assess the indexes' power to do just that. The tests indicate that as forecasters of inflation, commodity price indexes contribute no additional information beyond what is contained in the past history of consumer prices.

How are the indexes composed?

We analyzed the three most widely known commodity price indexes: the Commodity Research Bureau Futures Price Index (CRB), the Journal of Commerce Industrial Price Index (JOCCI), and the Change in Sensitive Materials Prices (SMPS).(2) Their main distinguishing characteristics are the commodity price used (futures or spot prices), the number of component commodities, and the weight attached to each commodity to calculate the index. As figure 1 shows, CRB is calculated on the basis of futures prices of 21 commodities, JOCCI is calculated on spot prices of 18 industrial commodities, and SMPS is calculated on spot prices of 12 crude and intermediate materials and 13 raw industrial materials. (Figure 1 omitted) Furthermore, CRB and SMPS assign equal weights to their components, while JOCCI assigns individual weights based on the components' estimated ability to lead consumer price inflation.

One major shortcoming of these commodity price indexes is the weighting scheme used to calculate them. When commodities are equally weighted, as the are in CRB and SMPS, for example, a 1% increase in the price of cocoa would have the same impact on the index as a 1% increase in the price of crude oil. …

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