Monetary Policy and Commodity Futures
Armesto, Michelle T., Gavin, William T., Federal Reserve Bank of St. Louis Review
This paper constructs daily measures of the real interest rate and expected inflation using commodity futures prices and the term structure of Treasury yields. We find that commodity futures markets respond to surprise increases in the federal funds rate target by raising the inflation rate expected over the next 3 to 9 months. There is no evidence that the real interest rate responds to surprises in the federal funds target. The data from the commodity futures markets are highly volatile; we show that one can substantially reduce the noise using limited information estimators such as the median change. Nevertheless, the basket of commodities actually traded daily is quite narrow and we do not know whether our observable rates are closely connected to the unobservable inflation and real rates that affect economywide consumption and investment decisions.
The Federal Reserve targets the interest rate on federal funds to implement monetary policy. The interest rate is composed of two unobservable factors, the real interest rate and a premium for expected inflation, which are important for understanding the appropriate setting of the target. Knowing how these two factors change in response to changes in the target is also important for implementing monetary policy. Empirical evidence about the level and changes in these factors is complicated by the lack of direct observations on them. (1) In this paper, we extract measures of the interest rate and expected inflation from commodity futures prices and use these measures to examine how interest rates and expected inflation respond to monetary policy shocks. Throughout this paper we use the terms inflation and real interest rate interchangeably with commodity price inflation and commodity own rate. Whether our results have important implications for monetary policy depends on how closely our measures derived from commodity markets are connected to the inflation rates and real interest rates that matter for consumption and investment decisions.
Since 1997, the United States has issued inflation-indexed bonds. By extracting observations about expected inflation and the real interest rate in this market, several studies have found evidence about how real and nominal interest rates react to monetary policy surprises. For example, Gurkaynak, Sack, and Swanson (2003) show that the implied forward 1-year rate at the 9-year horizon responds significantly to a surprise in the federal funds market. They find that the surprise is contained in the expected inflation premium and not in the implied forward real rate.
Kliesen and Schmid find a similar result for the 10-year rate (2004a) and for the real rate (2004b), but in their papers, it is not clear what part of the 10-year term structure is responding to the news. There is one drawback to these measures of the real rate and the expected inflation rate: The maturity of these investments is measured in years, and the analysis does not reveal information about the response of the real interest rate or expected inflation in the short end of the term structure.
Cornell and French (1986) provide indirect observations on the short end of the term structure by using a measure of the real interest rate extracted from commodity futures prices. They use this measure to gauge the reaction of real interest rates and expected inflation to surprises in the weekly money supply announcements between October 6, 1977, and March 23, 1984. Their results were somewhat surprising: They found that it was expected inflation in commodity prices and not real returns that went up when there was an unexpected increase in the money supply. These results were obtained using data after October 6, 1979, an era in which the Treasury bill (T-bill) rate responded strongly and positively to surprise increases in the money supply. Before this result, previous authors concluded that these increases in the T-bill rate were due to rising real interest rates--a liquidity effect, perhaps associated with sticky prices (Roley and Welsh, 1985) or with rationing in the market for borrowed reserves (Gavin and Karamouzis, 1985). …