Commodity Prices
Imported inflation?

What causes price inflation in developed countries? Is there a leading indicator of inflation? Are there factors other than primary commodity prices which cause inflation in the UK or in the OECD countries as a whole? These issues were addressed at a CEPR workshop on `Commodity Prices and Inflation' held in London on 4 November, organized by David Vines (University of Glasgow and CEPR) and L Alan Winters (University of Wales, Bangor, and CEPR). The workshop was held as part of a research programme on `Macroeconomic Interactions and Policy Design in an Interdependent World' supported by grants from the Ford Foundation and the Alfred P Sloan Foundation.
David Vines presented the first paper, on `Output, Inflation and Commodity Prices' (now available as CEPR Discussion Paper No. 271), written jointly with Thomas Moutos (University of Stirling). Vines introduced a simple model to highlight the interdependence between commodity prices and the rest of the economy. The model was similar to a Dornbusch model of floating exchange rates and emphasized the impact of forward-looking expectations. The model contained two goods: manufactured goods and primary commodities, with the latter assumed to be exogenously determined. Manufactured goods are used for consumption and investment. Primary commodities serve as a means of storing wealth, and in this capacity they are assumed to be perfect substitutes for bonds. The model includes a conventional LM curve for equilibrium in the money market and an equation for the rate of inflation, in which the price of manufactured goods is set as a mark-up on labour costs.
Vines and Moutos analysed both the steady-state and short-run effects on output and prices of changes in government spending, the rate of monetary growth and an increase in the exogenous supply of primary commodities. The analysis indicated that in some circumstances commodity prices `over-shoot' their new steady-state equilibrium value in response to changes in monetary policy. If commodities are a perfect substitute for bonds, fiscal expansion could lead to permanently higher output in the Vines and Moutos model. In addition, exogenous increases in the supply of primary commodities increase output and may lead commodity prices to overshoot.
Discussing the paper, George Alogoskoufis (Birkbeck College, London, and CEPR) observed that the behaviour of primary commodity producers was not captured in the model. It also appeared that the model allowed the consumers of primary commodities to have a `free lunch' in the sense that nothing in the model stops consumption being permanently larger than production. Stressing a similar point, Wilfred Beckerman (Balliol College, Oxford) noted that profits made by producers did not appear in the model. Many participants found too restrictive the `arbitrage condition' which linked the yield on commodities to that on bonds (for which they were a substitute in portfolios). David Newbery (Department of Applied Economics, Cambridge, and CEPR) argued that commodity stocks are not held for long periods and that such an arbitrage condition may not hold in the long run. David Currie (London Business School and CEPR) suggested that flow demand and flow supply for primary commodities should be equal in the long run, and that the arbitrage condition should hold in the short run. The model would then be over-determined and there would be a role for, say, fiscal policy in removing this over-determination so as to ensure long-run commodity market balance. Vines agreed that the model he had presented was very simple but argued that the main problem was how best to linearize an inherently non-linear system.

James Boughton (IMF) presented his joint paper with William Branson (Princeton University and CEPR) on `Commodity Prices as a Leading Indicator of Inflation'. Boughton claimed that commodity prices might serve as a useful leading indicator of inflation in the developed countries. Commodity prices, he noted, were determined in relatively flexible auction markets and as a result tended to respond quite quickly to disturbances, especially monetary ones. Boughton and Branson had analysed the conventional trade-weighted commodity price indices. Cointegration tests revealed no evidence of a long-run relationship between the levels of commodity prices and consumer prices in developed countries. The authors did find a tendency for changes in commodity prices to precede changes in consumer prices, when the data are denominated in a broad index of major currencies. When the prices are denominated in US dollars, however, the consumer price index appears to lead commodity prices. This highlights the need to take into account the exchange rate when analysing these relationships. Boughton concluded that turning points in commodity price inflation do tend to precede turning points in consumer price inflation in large industrial countries as a group.
Chris Gilbert (Queen Mary College, London, and CEPR) discussed Boughton and Branson's empirical evidence. There was some basis for their conclusions, but Gilbert argued that the relationship was not systematic and that the leads and lags varied considerably over time. David Vines proposed estimating an equation in which consumer prices depended on current and lagged values of the money supply: one could then introduce commodity prices and test whether they added significantly to the explanatory power of the regression. Sean Holly (London Business School) suggested that the relationship between commodity prices and inflation should be tested in a complete model in which there were other variables, such as wages, as possible predictors of inflation. Boughton agreed that these suggestions were worthwhile and that fully specified models might provide better indicators; his analysis, however, was designed as an exercise in signal extraction from actual data rather than as an attempt to generate predictions from a full modelling exercise. David Currie suggested that in this case a wider range of indicators should be considered.
Penelope Rowlatt (National Economic Research Associates) presented a paper entitled `Analysis of the Inflation Process'. A full understanding of the inflation process required, she argued, the separation of the internal dynamics of the domestic inflation spiral from other factors that could be treated as exogenous to it. These exogenous factors might include market disequilibria, the rate of inflation in other countries, deviations of rates of growth from their trend or their expected levels, changes in the rates of taxation or in the real levels of administered prices. Rowlatt's analysis modelled price-setting behaviour in each market using an equation based on microeconomic theory, with actual parameters taken from the UK Treasury model. These equations were combined into a model of the inflation process, which allowed her to distinguish the main influences on UK price inflation in recent years. She assessed the relative importance of changes in the real cost of primary commodities, increases in the export prices of other countries' finished goods (expressed in their own currencies) and domestic factors, such as the effects of macroeconomic policies, which caused upward pressure on inflation in the 1970s and a downward influence in the early 1980s.
David Currie argued that Rowlatt's model had many gaps: monetary policy was not modelled explicitly, for example, and the wage-price mechanism could have been affected by other variables, such as changes in output and employment, which she took to be exogenous. Vines pointed out that since the import prices considered in Rowlatt's model were total import prices rather than primary commodity prices, they may produce misleading estimates of the effect of primary commodity prices on inflation. Alan Winters also stressed this point, inquiring how the prices of oil and other primary agricultural products entered into the model. Even if oil is treated as an import, Britain does produce primary commodities agricultural products so the domestic price level contains a commodity price component. Michael Artis (University of Manchester and CEPR) argued that the results obtained from Rowlatt's model depended on the assumptions concerning input-output coefficients. Rowlatt had relied on the 1979 input-output table, and the results might be quite different if coefficients from a recent input-output model were used instead.
Annalisa Cristini (Institute of Economics and Statistics, Oxford) presented a paper on `Commodity Prices and World Activity'. She qualified the paper's title, interpreting the `world' as the OECD countries. Her macroeconomic model of the OECD was based on Nickell and Layard's analysis of labour markets. Cristini's model assumed that the OECD imports only primary commodities and produces only manufactured goods. The product market was assumed to be imperfectly competitive, so that firms face a downward-sloping demand curve and set prices based on a mark-up on marginal costs. Wages depend both on labour market pressure variables and on real wage resistance factors. Cristini's model indicated that commodity prices were dependent on activity in the OECD countries in the short run, but not in the long run. In the long run an increase in taxes was found to increase unemployment, reduce real wages and consequently increase the real interest rate, leading to inflationary pressure and higher prices. Oil price increases were found to increase commodity prices in the long run, inducing real wage resistance, higher wages and accelerating inflation.

David Vines commented that the absence of any influence of OECD economic activity on commodity prices in the long run is equivalent to a horizontal long-run supply curve for primary commodities. While this is consistent with estimates of reduced-form equations, studies based on structural estimates tend to conclude otherwise. Such a result is of vital importance, since it will strongly influence all the long-run properties of the model. James Boughton and Prathap Ramanujam (University of Glasgow) both argued that the assumption that all imports of OECD countries are primary commodities and all exports are manufactured goods may not be appropriate. At present OECD countries in fact export more primary commodities than the LDCs. Furthermore, it was argued, Cristini's aggregation of all primary commodity prices into one price index was unsatisfactory: in particular, those primary commodities produced within the OECD should be treated differently from the rather different primary commodities produced elsewhere.
David Currie pointed out that the paper presented by James Boughton had failed to find any long-term relationship between consumer prices and commodity prices, while Cristini's paper suggested that such a relationship does exist. Currie wondered whether these somewhat contradictory findings could be reconciled by taking account of the influence of exchange rate changes among the OECD countries.
David Vines, concluding the workshop, noted that it was a useful prelude to CEPR's March 1989 conference on `Primary Commodity Prices: Economic Models and Economic Policy.