Key Takeaways
- Commodities can act as a hedge against inflation, but their prices often reflect global currency strength rather than domestic inflation.
- Commodity markets are priced in U.S. dollars, causing prices to fluctuate with the dollar’s strength, directly impacting inflation.
- Unique economic shocks, like natural disasters, can cause commodity prices to spike independently of general inflation trends.
- The commodity-inflation correlation has weakened over time, making commodities less reliable as sole inflation indicators.
Commodities, from oil and gas to precious metals, are often viewed as signals of inflation, though globalization and shifting supply chains can weaken that link. Changes in the U.S. dollar can show up more clearly in commodity prices than in everyday consumer goods, since many commodities are priced in dollars and often move lower when the dollar strengthens.
This article explains how commodity prices can feed into inflation, when those signals tend to hold up, and when they can point you in the wrong direction, so you can use them more thoughtfully in financial planning.
How Economic Shocks Affect Commodity Prices
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.
Understanding the Pass-Through Effect on Inflation
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.
Evaluating the Commodity-Inflation Relationship
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.
