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VOL. 6, NO. 14
DECEMBER 2011­­

EconomicLetter
Insights from the

FEDERAL RESERVE BANK OF DALL AS

Relating Commodity Prices to Underlying
Inflation: The Role of Expectations
by J. Scott Davis

If the central bank loses
control of inflation
expectations, a temporary
increase in headline
inflation can heighten
long-run inflation
expectations, and an
otherwise short-lived
commodity price spike
will feed underlying
core inflation.

T

emporary supply factors may boost some commodity prices—a
drought in the Midwest can jolt food costs, or a conflict in the
Middle East might propel oil higher. These, in turn, can increase the overall
consumer price index (CPI) and the headline inflation rate.
Because central bank anti-inflation measures sometimes take a long
time to affect prices, policymakers don’t necessarily react to short-term fluctuations in headline inflation (an overall rate that’s not seasonally adjusted).
In fact, the mandate of many inflation-targeting central banks is to aim to
keep headline inflation at a certain target or within a certain range “over
the medium term,” widely recognized as a few years. Thus, even a strict
inflation-targeting central bank doesn’t aim to contain short-run headline
inflation fluctuations.
Still, fluctuations in headline inflation due to temporary commodity
price increases may not be transitory. If a rising headline rate is factored
into longer-run inflation expectations, temporary commodity surges may
produce a more permanent increase in underlying core inflation—the
closely watched rate that excludes categories such as food and energy that
are subject to wide swings.
A major development in the theory and practice of central banking
occurred during the second half of the 20th century: improved understanding of inflation expectations and their role in price setting. When
businesses set prices that will remain fixed for an extended period, they
must factor in not only input costs today, but also those expected in the
future. Similarly, when workers sign multiyear labor contracts, they must
anticipate future costs of living during the life of the agreement.
If the central bank loses control of inflation expectations, a temporary
increase in headline inflation can heighten long-run inflation expectations,

Commodity Spikes and Core Inflation
The post-World War II macroeconomic history of the United States has
witnessed both phenomena. Chart 1A
depicts the paths of core and commodity price inflation in the U.S. since
the late 1950s. The Fed lost credibility
and control of inflation expectations

and an otherwise short-lived commodity price spike will feed underlying core
inflation. But when inflation expectations remain anchored, a temporary
headline inflation fluctuation will not
feed into the underlying core rate.
Food or energy price spikes of limited
duration won’t matter.

Chart 1

Commodity Price Inflation’s Effect on Core Inflation,
Inflation Expectations
A. Commodity and Core Relationship Changes Around 1980
Percent
14
Core inflation

12
10
8
6
4
2
0
–2

Commodity inflation

–4
–6
’57

’62

’67

’72

’77

’82

’87

’92

’97

’02

’07

’02

’07

B. Commodity and Inflation-Expectations Relationship Changes Post-1980
Percent
14
12

Inflation expectations

10
8
6
4
2
0
–2

Commodity inflation

–4
–6
’57

’62

’67

’72

’77

’82

’87

’92

’97

SOURCES: Haver Analytics; Bureau of Labor Statistics; Federal Reserve Bank of Philadelphia.

EconomicLetter 2

F EDERA L RE SERVE BANK OF DALL AS

during the 1970s. The chart shows
how core inflation closely trailed commodity price inflation in the 1970s,
particularly after the oil price shocks of
1973 and 1979.
It has been widely noted
that beginning in 1979, under Fed
Chairman Paul Volcker, the central
bank regained its lost credibility. Since
the mid-1980s, core inflation has been
unresponsive to temporary commodity price fluctuations, which appear to
revert to the underlying core rate after
spiking, Chart 1A also shows.
We can quantify the extent to
which core inflation follows commodity price inflation (or vice versa) by
examining the relationship of changes
to each and the gap between them
(Table 1).1
In particular, suppose that the
current rate of commodity price inflation exceeds the core inflation rate by
1 percentage point (perhaps due to a
spike in commodity prices). On average, does a gap of that sort predict
an increasing core inflation rate over
the coming months, and if so, by how
much? If the effect is close to a 1-percentage-point increase in the core rate,
the gap will narrow mainly as a result
of core inflation catching up to commodity price inflation. If the effect is
close to zero, core inflation tends not
to respond to commodity price inflation spikes.
At the same time, what effect, on
average, does the same 1-percentagepoint difference have on the future
commodity price inflation rate? Does
the gap predict a decline in the rate of
commodity price inflation over coming
periods, and if so, by how much? If
that effect is close to a 1-percentagepoint decline in the rate of commodity
price inflation, the gap will narrow
mainly as a result of commodity price
inflation reverting to the core inflation
rate.
The estimates show there is a
major difference in the relationship
between commodity price inflation
and core inflation in the pre- and postVolcker Feds. In the 1957–79 period,

the effect of the commodity–core gap
on subsequent core inflation is positive and statistically significant, while
the impact on subsequent commodity price inflation is not significantly
different from zero. This implies that
during the 1960s and 1970s, core
inflation tended to follow commodity
price inflation, while commodity price
inflation did not revert to underlying
core inflation. The estimated effect on
core inflation implies that if commodity price inflation exceeds core inflation by about 1 percentage point, core
inflation would be expected to rise by
a half-percentage point in the next six
months.
This pattern is reversed in the
post-1984 period. Now the estimated
effect of the gap on core inflation is
not significantly different from zero,
and the estimated effect on commodity
price inflation is negative and significant. Core inflation is unresponsive
to fluctuations in commodity price
inflation, and deviations in commodity price inflation tend to revert to the
underlying core rate.
Commodity Prices and Expectations
A change in the relationship
between commodity price fluctuations
and inflation expectations lies behind
this abrupt shift in the relationship
between commodity and core inflation.

Since commodities are usually
traded in perfectly competitive markets—featuring an abundance of buyers and sellers where no single entity
dominates—prices are very flexible.
By comparison, prices in the core
CPI—the headline rate, less volatile
food and energy components—tend
not to move as easily, or are “stickier,”
in economics parlance. Expectations
of future prices matter when a price is
set and will remain fixed for a period
of time.
Thus, a temporary shock to commodity prices can lead to higher inflation expectations, which are incorporated into the price- and wage-setting
process. This process is also referred
to as the “second-round effect.” In the
first round, the commodity price shock
causes a temporary increase in headline inflation; in the second round,
inflation expectations can become
entrenched, and even a temporary
shock to commodity prices can produce a persistent increase in the core
rate.
Commodity price inflation’s
impact on overall inflation expectations
determines the strength of the secondround effects and, consequently, the
extent to which commodity price fluctuation drives the underlying core rate.
The paths of commodity price
inflation and one-year-ahead infla-

Table 1

Measuring the Impact of Changes to Commodity
and Core Inflation
Effect of 1-percentage-point difference between the commodity price inflation rate and
core inflation rate on subsequent core and commodity price inflation:
1960–79

1984–2007

Change in core inflation rate

0.488*

0.029

Change in commodity inflation rate

0.187

–0.546*

* Statistically significant at the 5 percent level.
NOTES: The effects are estimated from regressions using U.S. Consumer Price Index data sampled at a six-month
frequency. Changes in inflation rates are between current rates and rates six months in the future.

F EDERAL RESERVE BANK OF DALL AS

tion expectations, as calculated by the
Federal Reserve Bank of Philadelphia’s
Livingston Survey, are depicted in
Chart 1B. As we should expect, the
path of inflation expectations is similar to the path of core inflation in the
chart. Both were high and variable
in the 1970s, with spikes following
the 1973 and 1979 oil price shocks,
and have steadily decreased since the
mid-1980s.
The plots of commodity price
inflation and inflation expectations
seem to suggest that before 1979, a
commodity price increase led to rising inflation expectations about a year
later. Since the mid-1980s, this pattern has no longer held, and inflation
expectations seem relatively unresponsive to commodity price fluctuations.
It’s possible to quantify the extent
to which inflation expectations follow
commodity prices (or vice versa), just
as we did with respect to core inflation. In this case, imagine that the rate
of commodity price inflation exceeds
the current rate of expected inflation
by 1 percentage point. Does expected
core inflation subsequently rise, and if
so, by how much? Or does commodity
price inflation subsequently fall back
toward the expected core rate?
If the estimated effect on expected
inflation is close to 1 percentage point,
fluctuations in commodity price inflation—even temporary ones—are incorporated into inflation expectations.
If the effect is close to zero, inflation
expectations are unresponsive to commodity price movements.
As before, we can divide the data
into pre-1979 and post-1984 samples.
In the pre-1979 data, a 1-percentagepoint excess of commodity price inflation over expected inflation predicts
a nearly 0.2-percentage-point increase
in expected inflation over the next
six months (Table 2).2 Thus, there is
a tendency for inflation expectations
to “catch up” with commodity price
inflation in the earlier sample. At the
same time, the effect of the gap on
subsequent commodity price inflation
doesn’t differ in a statistically signifi-

3 EconomicLetter

EconomicLetter
Table 2

Commodity Inflation Impact on Price Expectations Evolves
Effect of 1-percentage-point difference between the commodity price inflation rate and the
expected inflation rate on subsequent expected inflation and commodity price inflation:
1960–79
Change in expected inflation rate

0.188*

Change in commodity inflation rate

–0.064

1984–2007
0.078*

is published by the
Federal Reserve Bank of Dallas. The views expressed
are those of the authors and should not be attributed
to the Federal Reserve Bank of Dallas or the Federal
Reserve System.
Articles may be reprinted on the condition that
the source is credited and a copy is provided to the
Research Department of the Federal Reserve Bank of
Dallas.
Economic Letter is available free of charge by
writing the Public Affairs Department, Federal Reserve
Bank of Dallas, P.O. Box 655906, Dallas, TX 752655906; by fax at 214-922-5268; or by telephone at
214-922-5254. This publication is available on the
Dallas Fed website, www.dallasfed.org.

–0.489*

* Statistically significant at the 5 percent level.
NOTES: The effects are estimated from regressions using U.S. Consumer Price Index and Livingston Survey data sampled
at a six-month frequency. Changes in inflation rates are between current rates and rates six months in the future.

cant way from zero, implying no tendency for commodity price inflation to
revert to expected inflation.
Results from the post-1984 sample
show the gap still predicts a statistically significant effect on inflation expectations—so there is still some tendency
for inflation expectations to catch up
with commodity price inflation—but
the size of the effect is much smaller.
Also, the estimated impact on subsequent commodity price inflation is
negative and significant, implying that
fluctuations in commodity price inflation will tend to quickly fall back to
the underlying expected inflation rate.
These calculations show that
because of changing expectations,
core inflation that in the 1970s reacted
so strongly to fluctuations in commodity price inflation responds very little
today. In the 1970s, the public was
quick to change its outlook for future
inflation in response to temporary
commodity price shocks. However,
in more recent decades, expectations have been largely unresponsive
to commodity prices. This change is
particularly significant as workers and
businesses set prices that reflect not
only current costs but also those in
the future.
Thus, inflation expectations form
the link between temporary fluctuations in commodity prices and underlying core inflation. If the Federal
Reserve is able to anchor inflation
expectations and prevent them from

rising following a commodity price
shock, it successfully breaks the link
between commodity prices and core
inflation.
Davis is a research economist in the Research
Department at the Federal Reserve Bank of Dallas.
Notes
1

Standard errors for the regression results are as

follows: For the effect on core inflation, the standard
error is 0.099 in the earlier sample and 0.025 in the later
sample. For the effect on commodity price inflation, the
standard error is 0.143 in the earlier sample and 0.157
in the later sample.
2

For the effect on expected inflation, the standard error

is 0.036 in the earlier sample and 0.026 in the later
sample. For the effect on commodity price inflation, the
standard error is 0.108 in the earlier sample and 0.139
in the later sample.

Richard W. Fisher
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Editor
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