MacroScan - Global Commodity Prices : High Volatility , Low Income

Primary commodity prices are well known to be highly volatile. Indeed, they are not just subject to short boom and bust cycles driven by demand and supply shocks, but also longer term cycles and secular trends driven by more structural and evolutionary forces.

There are many reasons for such volatility. First there is the strong relationship between climatic change and weather conditions. What is often less noted is the fact that even demand conditions are affected by weather, such as the demand for oil. Since the demand for most primary commodities is anyway less price-elastic than for manufactures, this means that any variability in supply gets associated with far greater price variability than in the case of manufactured goods.

In the case of perishable commodities, supply is inevitably very inelastic in the short term. For certain other primary commodities such as tree crops, the complete production process takes considerable time so that shifts in demand have a large impact on price in the intervening period.

For perishable primary commodities in particular, the costs of holding inventories tend to be high, which further affects price response. Since holding inventories of virtually all primary commodities, even the non-perishable ones, tends to involve significant costs, they are in turn significantly affected by the prevailing rate of interest. Thus movements in the rate of interest, which change the costs of holding these inventories, can be associated with changes in product price as such stocks are released to or withdrawn from the market by private traders. This tendency, which was noticed a century ago, is still an important element in the various forces making for commodity price volatility.

Indeed, even producers' organisations which are often intended to stabilise world market prices in particular commodities can have the opposite effect if they contribute to volatility through large shifts in supply. One example of this is OPEC, which has certainly affected international oil prices through its changing decisions on production and supply.

However, even by the standards of the past, the volatility of primary commodity prices appears to have increased quite dramatically in the past two decades. As Chart 1 indicates, primary commodity prices have been more volatile than the prices of manufactures in the last two decades, and both oil prices and non-oil commodity prices have fallen relative to the prices of manufactures. The chart provides data from the World Bank for the period from 1984 to late 1999. The unit value index of manufactures in this chart relates to the manufactures exported from the G–5 countries (France, Germany, Japan, United Kingdom, and United States) weighted by the country's exports to developing countries.
Chart 1 >>

This evidence of higher volatility is confirmed by other studies, all of which suggest that the volatility of primary commodity prices increased sharply following the collapse of the Bretton Woods system in the early 1970s and has remained high thereafter, going up further in the 1990s. According to the World Bank publication Global Economic Prospects for Developing Countries 2000, the standard deviation of the absolute value of the year-on-year changes in the non-energy commodity price index during 1970–98 was 11.5, compared with 5.7 for the manufactures unit value index during the same period.