Commodity Prices and Monetary Policy

Commodity prices are back. This paper looks at connections between monetary policy, and agricultural and mineral commodities. We begin with the monetary influences on commodity prices, first for a large country such as the United States, then smaller countries. The claim is that low real interest rates lead to high real commodity prices. The theory is an analogy with Dornbusch overshooting. The relationship between real interest rates and real commodity prices is also supported empirically. One channel through which this effect is accomplished is a negative effect of interest rates on the desire to carry commodity inventories. The paper concludes with a consideration of two implications for monetary policy: (1) an argument for putting commodity prices on the list of monetary conditions indicators that central banks look at, and (2) an argument – relevant for countries that experience large terms of trade fluctuations – for emphasizing commodity export prices in the price index that enters any target, rather than using the CPI.