Commodity Price Volatility and Monetary Policy Uncertainty: A GARCH Estimation

Commodities are on the move. In July of this year commodity prices reached near-record highs. Then, almost as quickly as they rose, commodity markets collapsed and prices fell to levels not seen in over a year. Until this collapse, commodities had enjoyed a bull market since late 2001, with the last two years witnessing the most significant rise in commodity prices in almost two decades. The staggering gains of commodities in 2007 and 2008, led by dramatic increases in energy and gold prices, seemed out of place given the softening economy and the collapsing housing market. A contentious debate began among consumers immediately pointed to speculation, the age-old scapegoat of rising prices. However, the erratic behavior of commodities suggests larger macroeconomic forces are at play. All asset classes, including bond, stock and foreign exchange markets are susceptible to macroeconomic and monetary policy forces. Commodities are no exception. Since the oil embargo of the 1970s, which saw both commodity prices and inflation rise exponentially, economists have debated on the dynamics of commodity prices and monetary policy. Over the last twenty years, the FOMC of the Federal Reserve board has implemented a number of different practices meant to increase the transparency of monetary policy. This increased transparency is witnessed through reductions in the prediction errors of federal funds futures contracts. The interrelationship between the fed monetary policy uncertainties and commodity price movements is the primary focus of this study. Additionally, this paper will analyze the way monetary forces alter the volatility of commodities prices. It will question whether uncertainties in interest rates spur price movements of both gold and an index of primary commodities. Ultimately, the study finds that monetary policy uncertainties, as measured by the prediction error of the federal funds futures price, are a significant predictor of price volatility in gold and contribute the futures price level for the commodity index. The argument will be prefaced by a review of the relevant literature followed by the specific research question, reasoning, methodology and empirical results.