Fed and commodity prices

Fatih Macit

Besides demand and supply dynamics, the policy stance of United States Federal Reserve (Fed) also has a significant impact on prices in commodity markets. The prices of main commodities, in particular oil prices, have realized a significant decline since the second half of 2014 and the speed of recovery partly depends on the actions that are going to be taken by the Fed. It is highly probable the Fed will increase the interest rates in its December meeting. However, the primary determinant for oil and other commodity prices will be the message the Fed gives about its future policy stance.

When the U.S. economy entered a recession in 2001, the Fed responded to the slowdown in economic activity by reducing the federal funds rate to historically low levels. In early 2001, the effective federal funds rate was higher than 5 percent. However, by the end of the year the rate was below 2 percent. The Fed continued to decrease the federal funds rate and by the end of 2003 the interest rates were at 1 percent, which had not been seen since 1954. These efforts paid off and from 2003-2006, the average real GDP growth in U.S. was higher than 3 percent. 

This excessive monetary easing by the Fed was a turning point for commodity prices, in particular oil prices. The accommodative monetary policy adopted by the Federal Reserve had generated an upward pressure on oil prices that can be explained by two reasons. First of all, the expansionary monetary policy had stimulated economic growth not only in U.S., but all over the world. The boom in global economic activity in turn increased the demand for oil and created an upward trend in oil prices. Secondly, the low level of dollar interest rates had led to a depreciation of the dollar and the euro/dollar exchange rate increased from 0.859 to 1.560 between 2001 and 2008. The weakening of the dollar also put an upward pressure in oil prices and other commodity prices. As a result of these two impacts, oil prices increased from 25 dollars to 150 dollars between 2002 and 2008. However, the prices showed a sharp decline in 2009 due to the global financial crisis and dropped to 40 dollars. The Fed’s response to the crisis was more aggressive compared to the one in 2001. They reduced the interest rates to zero and printed more than 2 trillion dollars in three years’ time. The extensive quantitative easing program generated another rally in oil prices, which reached three-digit levels again in 2011 and stayed at these levels until the sharp decline in the second half of 2014.

Among developed economies, the U.S. economy experienced the fastest economic recovery after the 2009 global financial crisis. The unemployment rate declined to pre-crisis levels and the GDP growth reached long-term averages. Therefore, it is highly likely that in the December meeting the Fed will increase interest rates again almost a decade later. If the Fed raises the interest rates in December but then waits to see the developments in the labor markets and inflation, this will give support to commodity prices at least in the short run. Therefore, under this scenario we might see some recovery in oil and other commodity prices in 2016. In the second scenario the Fed will raise the interest rates in December and successive rises will follow in 2016 and 2017. If the Fed gives a message that will make the second scenario more likely, commodity prices will stay under pressure not only in the medium-term but also in short-term. Looking at the developments in the U.S. economy and global financial markets, it seems that the first scenario is more likely to occur. On the inflation side, a strong dollar and low energy prices keep the actual inflation rate far below the level that is targeted by Fed. Besides these factors, the fragile economic environment in China and other developing economies will probably not allow the Fed to continue increasing the interest rates next year. Although one should not expect a strong rally, we might see a partial recovery in commodity prices in 2016.


*Assoc. Prof. Fatih Macit, Senior Fellow at Hazar Strategy Institute and Head of the Department of Economics and Director of the Center of Economic Studies at the Suleyman Shah University (fmacit@ssu.edu.tr)