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High and volatile commodity prices weight heavily on the overall economy

Environnement & Ressources Naturelles 
Billet du 28 mai 2012
Par Valérie Mignon, Sophie Piton
Commodity markets have recently been at the center of the world economic concerns: their increasing prices and high volatility frighten. A special issue of International Economics focuses on explaining the recent developments on commodity markets.
Recent evolutions in commodity prices remain a major cause for concern…
For several decades, commodity prices have been subject to high volatility weighing heavily on the overall economy. A typical example is given by the fluctuations in oil price which appear exceptionally uncertain in both the short term (Figure 1a) and long term (Figure 1b). This global picture is also observed for many other raw materials, as illustrated in Figure 2. They exhibit high volatility, as well as a considerable increase in prices between 2006 and 2008. The “All commodities” index, which was set at 100 in 2005, followed an upward trend since the end of the 1990’s up to a maximum at 219 in July 2008: it has more than doubled in just three years. 

Source: Crude oil prices in USD per barrel extracted from Datastream (Figure 1a) and BP Statistical Review (Figure 1b)
Data source: IMF, International Financial Statistics (IFS)
These sharp and wide movements in commodity prices have heavy impacts on the overall stability of economies. Since the mid-1970’s, oil price movements have been considered as the main source of business cycle fluctuations.[1] The 2007-2008 food crisis and the corresponding food riots have dramatically illustrated the consequences of such movements in developing countries, affecting both the purchasing power of poor consumers and producers’ income. Volatility of commodity prices has thus become a central issue for the world economy. It has led the G20 to address the issue of excessive fluctuations and volatility of commodity prices for the first time. During the September 2009 Pittsburgh summit, a commitment was taken to improve the functioning, regulation and transparency of financial and raw materials markets.
…Especially because it is difficult to explain their dynamics
Evolutions of commodity prices could obviously be partly explained through fundamentals, especially by the commodity-based growth of emerging countries or the development of biofuels. But if commodity prices could be anticipated, the G20 would not have given such priority on moderating them. What is worrying is the extreme volatility of prices. Excessive price fluctuations generate uncertainty and, consequently, disrupt the economic agents’ expectations. Therefore, understanding the behavior and the dynamics of commodity prices is a rather difficult task for economists and econometricians. Some economists argue that commodity prices are fundamentally unstable because of the nature of such goods, especially for agricultural goods.[2] But recently, financial motives were condemned as the main cause of their instability.
Derivatives were initially introduced for commodities and the Chicago Board Of Trade was the first exchange place created in 1848 for commodities. Forward trading was initially aimed at insuring agricultural prices for producers, as agriculture is subject to much variability (weather events, diseases, soil productivity…). In recent years, derivatives exchanges for commodities grew importantly. New financial products were created, leading to the so-called financialization of commodity markets. Since 2000, investors can speculate on indexes reproducing commodity prices evolutions.[3] This activity, referred to as index trading, has been subject to much criticism. It is blamed for being the source of stronger volatility as it seems to lead to growing comovements of commodity prices (i.e. prices of every commodity tend to evolve more and more closely), decoupling them further from fundamentals. However, only very few studies suggest evidences of an impact of index trading on commodity prices, most of them showing very mixed results.[4] G. Capelle-Blancard and D. Coulibaly confirm, in a recent issue of International Economics, the lack of evidence to assume that index trading impacts commodity prices.
The recent issue of International Economics intends to cast the light on the recent trends in commodity markets. The various articles give a comprehensive view on the subject, focusing on the functioning of financial markets for commodities and their regulation, on the impact of fundamentals on prices and the channeling of volatility in price to consumer goods. It also addresses environmental issues, a subject especially intertwined with commodities as worries grow about climate change and carbon tends to behave like a commodity.

[1] Lescaroux and Mignon, 2008a, 2008b.
[2] For example, the cobweb theorem by Ezekiel, 1938.
[3] For more information on the financialization of markets, see Aglietta and Emlinger in L’Economie Mondiale 2012, the annual CEPII publication.
[4] See Sanders, Irwin, 2010.

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