On the heels of an unexpected 50 basis point reduction in the federal funds rate by the Federal Open Market Committee (FOMC), rising commodity prices have stoked investors’ concerns that inflationary pressures will soon ripple through the economy, whilst the FOMC looks the other way. Yet, although rising commodity prices are newsworthy, don’t bet on them to predict inflationary trends in the Bureau of Labor’s Consumer Price Index. Nor should investors assume that the FOMC has lost sight of its Congressional mandate to maintain price stability.
While conventional wisdom purports a solid connection between commodity prices and inflation, findings from a regional Federal Reserve Bank’s economic research group demonstrates otherwise. Simply put, times have changed.
In a 1996 study1, Federal Reserve Bank of San Francisco economists demonstrated that commodity price movements played a relatively strong and statistically robust role as a leading indicator of overall inflation in the 1970s and the early 1980s. However, the authors went on to show that the usefulness of commodity prices as stand-alone inflation indicators diminished markedly after that point.
Furthermore, a more recent analysis of the commodity price-inflation link from the Federal Reserve Bank of New York broadened the discussion, but did not alter the basic conclusion—the inter-connection of commodity prices and inflation waned years ago.2
All of which should prompt investors to ask a very logical question. If commodity prices are less reliable inflation forecasting tools, in and of themselves, then what single indicator is better?
The answer proposed by the same researchers at the Federal Reserve Bank of New York is quite interesting. They suggested projecting forward the
prevailing trend in previously reported inflation data might perhaps be the best guide for formulating expectations about the future course for inflation. Comprehensive evaluation informed this conclusion. The researchers studied 19 widely followed inflation indicators, including the price of oil and gold. While the team suggested a short-lived level of improved predictive quality versus trend analysis to some of these measures, none was so significant as to diminish the importance of the trend forecast. In other words, when it comes to formulating an inflation forecast, the fact that past performance has mattered most is not lost on members of the FOMC. And on that count, based on the most recently available data, trend inflation in the U.S. at 3.1 percent over the past 20 years, 2.8 percent over the past five years and 2.1 percent over the last year suggests to me that investor concerns over the prospect for renewed inflationary pressures may be misinformed.
1 Furlong, Fred and Robert Ingenito, “Commodity Prices and Inflation,”
Federal Reserve Bank of San Francisco
Economic Review, 1996 Number 2, pages 27-41.
2 Cecchetti, Stephen, Rita S. Chu and Charles Steindel, “The Unreliability of Inflation Indicators,” Federal Reserve
Bank of New York, Current Issues in Economics and
Finance, April 2000, Volume 6, Number 4
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