What Are the Implications of Rising Commodity Prices for Inflation and Monetary Policy?

By Evans, Charles L.; Fisher, Jonas D. M. | Chicago Fed Letter, May 2011 | Go to article overview

What Are the Implications of Rising Commodity Prices for Inflation and Monetary Policy?


Evans, Charles L., Fisher, Jonas D. M., Chicago Fed Letter


The recent run-ups in oil and other commodity prices and their implications for inflation and monetary policy have grabbed the attention of many commentators in the media. Clearly, higher prices of food and energy end up in the broadest measures of consumer price inflation, such as the Consumer Price Index. Since the mid-1980s, however, sharp increases and decreases in commodity prices have had little, if any, impact on core inflation, the measure that excludes food and energy prices.

Some economists argue that rising commodity prices are inflationary and, therefore, require a tightening of monetary policy.1 Others say rising commodity prices have sometimes led to inflation and sometimes not. Therefore, a monetary policy response may not be required.2 In this Chicago Fed Letter? we empirically assess these views by conducting a statistical analysis of quarterly data on commodity prices, inflation, and monetary policy since 1959. We find that since the mid-1980s, after the big oil shocks and the tenure of Paul Volcker as chairman of the Federal Open Market Committee (FOMC), the reactions of both core inflation and the federal funds rate (the monetary policy instrument) to shocks in oil and other commodity prices have been extremely modest. We use our estimates to assess the current stance of monetary policy.

Methodology

To assess inflationary pressures in the economy, we can look at many potential indicators of future inflation, such as rising commodity prices. But how do we determine the relative importance of these indicators? One objective approach is to include an indicator in an inflation-forecasting relationship and examine its contribution to improving forecasting performance. Using this approach, we find evidence from some single equation models that we track at the Chicago Fed that suggests commodity prices are poor predictors of changes in future core inflation. However, this might be because, as a credible inflationfighting central bank, the Federal Reserve has historically tightened policy to eliminate the inflationary consequences of large changes in commodity prices. Accounting for such monetary policy reactions is an interesting and subtle issue, and there are several valid approaches. Here, we employ a reducedform statistical framework.4 To identify the influence of monetary policy, we estimate the typical response of core inflation and the monetary policy instrument following an unexpected change in commodity prices. We study the influence of a credible inflation-fighting central bank by comparing responses in the pre- and post-Volcker periods.

We consider three distinct hypotheses:

* Weak central bank credibility hypothesis: If commodity prices have a substantial effect on actual inflation and the policy response is inadequate, we should see an increase in inflation following a commodity price increase. Presumably, this evidence would be most apparent during the pre-Volcker period (1959-79).

* Strong central bank credibility hypothesis: If commodity prices have a substantial effect on inflation and the policy response is adequate, we should see no significant increase in inflation following a commodity price increase. However, we should see a response in the fed funds rate, reflecting the tightening of monetary policy. This might be apparent in the post-Volcker sample period (1982-2008).

* A generally uninformative indicator hypothesis: If commodity prices were truly uninformative for inflation, they would generate insignificant responses of both inflation and the policy instrument.

We estimate these hypotheses with the vector autoregressive (VAR) model that Bernanke, Gertler, and Watson used to study monetary policy and the effect of oil price shocks.5 We use quarterly data for core PCE inflation (personal consumption expenditures without food and energy) , growth in real gross domestic product (GDP), growth of the Commodity Research Bureau's (CRB) Commodity Price Index (which consists of commodities other than oil), growth of the Producer Price Index (PPI) for crude petroleum, and the federal funds rate (FFR) . …

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