The Macroeconomic Determinants of Commodity Prices


WP/94/9-EA

The Macroeconomic Determinants of Commodity Prices by Eduardo Borensztein
and Carmen M. Reinhart

Commodity markets play a central role in transmitting shocks
internationally. Given this role, and the marked fluctuations in commodity
prices and volumes in recent years, a comprehensive analysis of the
macroeconomic factors having an impact on commodity markets becomes an
important factor in policy design, particularly for those countries that
rely heavily on primary commodity exports and that are facing substantial
terms-of-trade shocks.

While markets for individual commodities are affected by a variety of
specific factors in their day-to-day evolution, the aggregate index of non-
oil commodities has been treated as a variable whose movements on a
quarterly or annual basis are related to prevailing macroeconomic
conditions. Studies stressing a structural approach to commodity price
determination have found that two (demand-side) variables did well in
explaining the variation of commodity prices: the state of the business
cycle in industrial countries and the real exchange rate of the U.S. dollar.
By late 1984, however, the demand-driven framework began to systematically
overpredict real commodity prices by wide margins and the forecasts have
continued to be off-track, suggesting that one or more important variables
were being left out of the analysis.

The purpose of this paper is to identify the main economic fundamentals
that lie behind the behavior of commodity prices, particularly the recent
weakness, and quantify the relative importance of each of these factors over
time. The authors extend the traditional structural approach described
above by incorporating two important developments in international commodity
markets of the 1980s and 1990s. These were an increase in commodity exports
as developing countries tried to service burgeoning debts, and weaker demand
by the economies in transition combined with a sharp increase in the supply
of several commodities by these countries.

The main results can be summarized as follows. First, the constructed
commodity supply index markedly improves the fit of the structural model
and, more important, significantly reduces the out-of-sample overprediction
of real commodity prices. Second, while output in Eastern Europe and the
former Soviet Union appears to have played a minor role early in the sample
period, it acquires an increasingly important role in the more recent
period. And third, estimates using quarterly data suggest that while the
full structural model does not outperform a random walk forecast of real
commodity prices for short-term forecast horizons, it does do so for a
longer-term forecast horizon (5 to 31 quarters) and captures the major
turning points in real commodity prices during the 1985-1992 period.