The Correlation of Commodities to Inflation

In the mid-2010s, the global economy witnessed the U.S. dollar gain steam against other major currencies and saw oil prices freefall, along with several other macroeconomic events. Conventional wisdom suggests the health of the U.S. dollar has an inverse relationship to the price of imports and in this case, a strong U.S. dollar decreases the price of imports. However, import prices of consumer discretionary goods don't always move in sync with changes in the U.S. dollar, as foreign firms often choose to maintain its prices in the U.S. market.

Instead, the connection between import prices and the U.S. dollar is reflected by the tendency for commodity prices to fall when the dollar strengthens. The commodity markets are quoted in U.S. dollars so it may seem intuitive that when the dollar rises, commodity prices will decrease. Simply, a stronger U.S. dollar will impact inflation through commodity prices rather than consumer goods. So, a key factor to consider in anticipating how the currency will affect inflation is the behavior of commodity prices.

Unique Shocks

Commodity prices are believed to be a leading indicator of inflation through two basic channels. Leading indicators often exhibit measurable economic changes before the economy as a whole does. One theory suggests commodity prices respond quickly to general economic shocks such as increases in demand.

The second is that changes in prices reflect systemic shocks, such as hurricanes which can decimate the supply of agricultural products and subsequently increase supply costs. By the time it reaches consumers, overall prices would have increased, and inflation would be realized. The strongest case for commodity prices as a leading indicator of expected inflation is that commodities respond quickly to widespread economic shocks.

Pass-Through Effect

In the past, increases in oil prices were behind a strong increase in the price of goods and services. The reason for this is that oil is a major input in the economy and is used in critical activities such as heating homes and fueling cars. If the cost of oil increases, then the cost of manufacturing plastics, synthetic materials or chemical products will also rise and be passed onto consumers. This correlation was evident in the 1970s during the energy crisis. 

Weighing the Evidence

Whether its unique shocks or general price movements, the commodity-inflation relationship doesn't always hold. For example, an increase in the total demand for final goods and services can coincide with an increase in demand for manufactured goods relative to agricultural products. While this could lead to a rise in overall prices, prices of agricultural commodities might fall.

These types of occurrences suggest that commodity-inflation movements depend on what is driving the commodity change. Moreover, a stronger dollar in the global market will increase the price of commodities relative to foreign currencies. The higher price of commodities in foreign currency will work to lower demand and dollar-priced commodities. In this scenario, increasing commodity prices abroad could cause domestic deflation.

The Bottom Line

The simple two-way relationship between commodity prices and inflation has significantly declined over time. In the 1970s, the relationship was statistically and evidently robust. However, in the past 30 years, the correlation has become less significant. That being said, commodity prices performed well as an indicator of inflation when other factors influencing inflation like employment and exchange rate fluctuations were apparent.

Globalization has increased the interconnectedness of economies, and when commodity prices increase from a strong dollar, this typically results in domestic deflation. While commodity prices are not 100% indicative of inflation, they can be a good starting point when attempting to hedge against inflation.