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Exploring the Supply and Demand Drivers of Commodity Prices | Bulletin – June Quarter 2019
| Content Provider | Semantic Scholar |
|---|---|
| Author | Cunningham, Michelle L. Smith, Emma |
| Copyright Year | 2019 |
| Abstract | Quantifying the relative importance of supply and demand in price movements of commodities can help inform how changes in these prices might impact the Australian economy, via exports, business investment and the exchange rate. Isolating the extent to which a change in commodity prices is driven by demand also provides a timely indicator of global economic activity. In this article, we use a dynamic factor model to help interpret changes in commodity prices as being driven by supply and/or demand developments. Results from the model are consistent with prior understanding of several notable episodes of commodity prices movements. B U L L E T I N – J U N E 2 0 1 9 2 1 5 Why Do Commodity Prices Matter for the Australian Economy? Commodities account for two-thirds of the value of Australia’s exports. The prices of these commodities are important determinants of the terms of trade, Australian dollar, national income and aggregate demand. A better grasp of the underlying drivers of commodity price changes – supply and demand – can improve our understanding of how long a shift in commodity prices might last and how they might affect the Australian economy. For example, the response of export volumes to a change in price can depend on whether the change is driven by demand or supply. If prices rise because external demand has increased, then Australia’s export volumes are also likely to increase. In contrast, if prices rise because Australian supply is disrupted, export volumes are likely to decline, although the higher prices could more than offset the effect of this on the value of exports. Whether a price movement is driven by supply or demand can also shed light on how long it might last. A disruption to supply as a result of severe weather is likely to be temporary, and so will have little effect on the outlook for exports or investment. On the other hand, sustained demand-driven price rises can induce large-scale investment to expand capacity to meet that demand – with lasting effects, as the Australian experience of the past decade has shown (Plumb, Kent and Bishop 2013).[1] Commodity prices (and the terms of trade more generally) are important medium-term determinants of the value of the Australian dollar. Expectations of long-term future changes in commodity prices have been found to move closely with the currency (Chapman, Jääskelä and Smith 2018). Movements in commodity prices that are expected to be short-lived, such as those driven by temporary supply disruptions, tend to have a smaller effect on the Australian dollar. Commodities are used extensively in global industrial production, so a change in global activity could result in changes in demand for these commodities and, as a result, a change in their prices. Given the timeliness of data on commodity prices, this can provide a useful real-time indicator of global demand and can also provide a cross-check on the Reserve Bank’s forecasts of economic activity. In this article, we use an econometric technique to quantify the relative importance of changes in supply and demand for commodity price movements. In particular, we use a dynamic factor model of commodity prices that largely follows Delle Chiaie, Ferrara and Giannone (2017).[2] This technique uses information that is shared between different commodity prices and that which is commodity-specific (or idiosyncratic) to decompose price changes into the contributions from several unobserved factors, which may be loosely interpreted as supply and/or demand. This articles provides an overview of the model and its interpretation, discusses some key results and provides examples of its application to various episodes of commodity price movements. E X P LO R I N G T H E S U P P LY A N D D E MA N D D R I V E R S O F CO M M O D I T Y P R I C E S 2 1 6 R E S E R V E B A N K O F AU S T R A L I A A Dynamic Factor Model of Commodity Prices In general, factor models decompose changes in a large number of variables into a few unobserved statistically derived ‘factors’, which may be given economic interpretations. In our case, we take a range of commodity prices and decompose changes in these prices into factors that, as discussed below, we can generally interpret as capturing supply and/or demand developments. At the broadest level, all commodity prices are grouped together and a global factor that captures variation common to all commodity prices can be extracted (Figure 1). Stepping down a level, the model then groups together commodities with similar characteristics. For instance, commodities that are close substitutes (such as different types of crude oil) or those that have similar end uses (such as base metals used in industrial production) are grouped together.[3] Within each of these groups, referred to as blocks or sub-blocks, the common variation is extracted into an unobserved factor; this is the leftover common information between groups of commodities after the global component is extracted. When presenting the results from the factor model we aggregate the contribution of all block and subblock factors under block factors. Finally, the remainder is the commodity-specific, or idiosyncratic, component, which can also be thought of as the residual; that is, the change in the price that is not explained by the global or block factors. For more details on the model see Appendix A. |
| File Format | PDF HTM / HTML |
| Alternate Webpage(s) | https://www.rba.gov.au/publications/bulletin/2019/jun/pdf/exploring-the-supply-and-demand-drivers-of-commodity-prices.pdf |
| Language | English |
| Access Restriction | Open |
| Content Type | Text |
| Resource Type | Article |
