Introduction
The inflationary consequences of rising commodity prices represent an important challenge for monetary policy. Rising commodity prices result in an increase in inflation, but at the same time have negative consequences on economic activity. Their implications for monetary policy are less straightforward than those of demand shocks. For example, a positive demand shock that increase inflation and output calls for monetary tightening in order to stabilize both. However, the implications of commodity price shocks are less clear cut.
For the purpose of the discussion in this paper I will consider an economy that is a net importer of commodities, and local demand for the commodity is relevant. This commodity may be an intermediate input, such as oil, or a final good, such as gasoline or food. Therefore, a commodity price shock is an inflation shock and has negative effects on income at the same time. I will not focus on natural resource abundant economies, where the rise of commodity prices represents mainly a positive wealth effect, in particular when the fraction of the production of the commodity consumed at home is small.
Let us consider, for example, the case of oil. Inflation rises through the direct effects on gasoline prices and indirectly through a rise in costs. In addition, an oil price shock is analogous to a negative productivity shock. Therefore inflation rises and output slowdown. Although in principle one could think that the implications on monetary policy are ambiguous, they are not. Some degree of accommodation may be needed, and this depends on the output effects and the duration of the shock, but the direction of monetary policy is to reduce the monetary impulse.
The inflationary effect of an oil price shock requires a tightening of monetary policy. The effect on activity also needs tightening, since the effects on output are mostly a fall in full-employment output, since the energy shock is equivalent to a negative productivity shock, and hence the output gap increases, inducing further inflationary pressures. There are some caveats to this conclusion. As I discussed later on, there are mitigating demand effects, which could be very important in the case of a food prices shock, since the commodity prices may result in a decline in the terms of trade and national income. In addition, a credible inflation targeting regime may need a much smaller response when facing transitory supply shocks, and indeed as I document in this paper, the fact that the recent oil shocks have had small effects on inflation and activity hinge to a large extent on the conduct of monetary policy geared toward price stability.
The recent experience with commodity price shocks has been very significant. Since the mid 2000s all commodity prices started rising sharply (figure 1). The initial reaction in policy and academic circles was how to react to a transitory commodity price shock. In this case, there were good reasons to think that a short-lived price shock should not require decisive policy reaction. However, reality turned out to be quite different. Commodity prices kept rising to unprecedented levels and the change was much more persistent. Only at the peak of the subprime crisis, late 2008, commodity prices suffer a major reversal, but even in a world that has not fully recovered from the crisis, commodity prices rose again.
The magnitude and persistence of high commodity prices were not expected some years ago, and hence, it is not appropriate to conduct monetary policy under the assumption that the shock is temporary. Today is better to work with the assumption that there has been a persistent change in the relative price of commodities. Economies must adjust to these new relative prices, but during the adjustment monetary policy must avoid increases in inflation that may end up being too costly to revert. Excessive propagation feeds back into prices through indexation and rising inflationary expectations.
These two commodity price booms have resulted in higher inflation, and the purpose of this paper is to analyze some relevant issues from the point of views of monetary policy. For analytical purposes I will define two commodity price booms, one from the third quarter of 2006 to the third quarter of 2008, and the other from the third quarter of 2009 to the third quarter of 2011. The reason to define the episodes this way was to have equally sized episodes (2 years), which should facilitate comparisons.
The commodity price shocks resulted in an increase in food and energy inflation. They are mechanically passed into headline inflation. The magnitude of these effects depends on the weight of each component on the CPI. But in addition, there are the so-called second round effects, which refer to the indirect impact on other prices, through cost or demand pressures. Figures 3 and 4 show the correlation between food and energy inflation with headline and core inflation for a sample of 34 countries in both episodes. It is interesting to note that in most countries there was a relevant increase in food and energy inflation, which varies across countries and episodes. The simple correlation shows that the rise in food and energy prices had an effect on headline inflation.
The increase in food prices also had important second round effects, which, as the figures show, are already affecting core inflation two quarters after the shock started. The second round effects of energy are weaker, in particular during the second episode. This is consistent with the evidence discussed later on the relevance of food vis-à-vis energy in the propagation of inflation.
The paper follows in two main sections. Section 2 is devoted to an analytical discussion on commodity prices and monetary policy. In the first part I take on the issue of whether the target inflation should be done in terms of core or headline inflation, and regardless the target, how monetary policy must react to rising core and headline inflation. Despite core inflation is a better measure of underlying inflationary pressures, setting up the target in terms of headline inflation is desirable and it is the usual practice of central banks. In addition, ignoring the developments of headline inflation may lead to an underestimation of future inflation when hit by long-lasting commodity price shocks. Then, I present a very simplified model to discuss the channels through which commodity prices affect the economy and its implications on monetary policy. I distinguished the direct impact on inflation, and the impacts on full-employment output and aggregate demand.
In section 3 the paper looks at the empirical evidence of the two episodes of commodity price booms. It reviews the literature on second round effects and propagation, and present new evidence on the relevance of food and energy in the propagation of inflation. The evidence shows that energy has very limited second round effects, while those of food are much more important. The paper concludes in section 5 with some final remarks.