Written by: Jeffrey Frankel
CAMBRIDGE – Big moves in the prices of oil, metals, and agricultural commodities have been among the most notable economic developments of the past two years. The sharp rise in commodity prices during most of this period was virtually impossible to overlook. The price of a barrel of Brent crude, which sold for $20 in April 2020, during the first wave of the COVID-19 pandemic, peaked at $122 in March 2022, after Russia invaded Ukraine.
Oil was not the only commodity that saw an increase in prices. Copper price doubled. Wheat more than doubled; Global commodity price indices nearly tripled from April 2020 to March 2022. These increases are in dollars; So prices in euros, yen, won or other currencies rose even more.
However, it is not widely noted that the prices of many commodities have fallen this summer. The price of oil fell about 30% between early June and mid-August. The price of politically sensitive gasoline in the United States has fallen 20% over the same period, from $5 a gallon to $4 a gallon. The general index fell by 12%.
Is this drop in commodity prices only temporary? Or is it a sign that prices have peaked and are expected to fall further?
Commodity prices are highly correlated. One reason is the direct links to microeconomics. When the price of oil rises, the costs of wheat producers increase (because harvesting equipment runs on diesel and fertilizers are made from natural gas), which puts upward pressure on grain prices.
There are two macroeconomic reasons to believe that commodity prices in general will fall further. The level of economic activity is an intuitively important determinant of the demand for goods and, therefore, of their prices. Less obvious, the real interest rate is another key factor. Current projections for both global growth and real interest rates point to a downward trajectory for commodity prices.
Not all prices will go down. Different commodities tell different stories. For example, the market price of natural gas in Europe will rise further, as the continent will learn to manage winter without Russian supplies. But the trend is likely to be downward elsewhere.
Strong global growth, especially in China, could explain the surge in commodity prices in 2004-2007, 2010-11, and 2021. Conversely, declining global growth could explain the sudden drop in commodity prices during the Great Recession of Mid-2008 to early 2009 and during the pandemic recession from January to April 2020.
Global growth is currently slowing. The Chinese economy has faltered greatly. Growth there actually turned negative in the second quarter, as Shanghai and some other big cities suffered shutdowns as per President Xi Jinping’s pointless policy. The European economy will be hit hard by the side effects of Russia’s invasion of Ukraine.
Even growth in the US was slower in 2022 than it was last year, with many declaring that the recession had begun. (Personally, I’m still willing to bet that there won’t be a recession in the US in the first part of the year, and that first-quarter or second-quarter GDP will be revised upward by the end of September.)
In its latest update, the International Monetary Fund predicted a sharp slowdown in global growth, from 6.1% in 2021, to 3.2% in 2022 and 2.9% in 2023. Slower growth means lower demand for goods, and thus lower prices.
Moreover, with the US Federal Reserve and other central banks tightening monetary policy, real interest rates are likely to rise. This is likely to lower commodity prices, and not just because higher real interest rates increase the likelihood of a recession. The level of real interest rates affects commodity prices independently of GDP, both in theory and empirically.
The theory of the relationship between real interest rates and commodity prices has been well established for a long time. The simplest intuition behind this relationship is that the interest rate is the “carrying cost” of inventory. An increase in the interest rate causes a decrease in the demand of firms to hold inventories and thus lowers the price of goods.
Three other mechanisms operate, in addition to inventories. First, for a depletable resource, a higher rate of interest increases the incentive to extract today and thus expand the available supply. Second, for “funded” commodities, an increase in the interest rate encourages institutional investors to switch from a commodity asset class to Treasuries. Finally, for an internationally traded commodity, an increase in the domestic real interest rate causes a real appreciation of the local currency, which will lower the commodity’s domestic currency rate.
Standard economic analyzes have shown the statistical relationship between real interest rates and commodity prices. These simple correlations include regressions that control other important determinants, such as GDP and inventories in the carry trade model; and studies of high-frequency events that are less sensitive to the standard economic problems of regressions.
Two stages show that the effect of real interest rates on commodity prices operates independently of the effect of GDP. Neither the sharp rise in dollar prices of commodities in the first half of 2008 nor the decline in 2014-2015 can be explained by fluctuations in economic activity. Alternatively it can be interpreted as the result, respectively, of loose US monetary policy (QE) and tightening of US monetary policy with the end of QE.
Real interest rates appear to be on a steady upward trend, because nominal interest rates will rise, and inflation will fall. Combined with slowing global growth, this could mean a continuation of the recent decline in real prices of oil, minerals and agricultural products.