Monetary policy spillovers, global commodity prices and cooperation

BIS Working Papers  |  No 696  | 
30 January 2018
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 |  61 pages



Commodity price swings are key drivers of inflation and naturally factor into monetary policy decisions. Our paper assesses the soundness of the conventional wisdom that central banks should largely ignore the initial impact of commodity prices on headline inflation. This approach is based on the 1970s experience, when commodity prices soared because of supply shortages. Now, demand plays a more prominent role. Trying to distinguish between demand and supply, however, raises the risk of misdiagnosing commodity price falls as being driven primarily by external supply shocks, such as new discoveries of oil reserves, when they are in fact driven by global demand shocks, such as a fall in consumer confidence. We look at how misdiagnoses may affect the stability of the global business cycle.


We show how to assess the monetary policy implications of misdiagnosing the drivers of commodity prices for output and inflation stabilisation. With our state-of-the-art approach, we examine the effectiveness of different monetary policy strategies and, therefore, of the conventional wisdom.


In general, the conventional approach fares poorly in our assessment. Targeting supply and demand shocks improves outcomes. However, this advice comes at a risk. Misdiagnosing the source of shocks is costly. Indeed, we argue that there is an inherent tendency for small economies to treat changes in commodity prices as being driven by global supply shocks even when the true driver is global demand. In this situation, central bank reactions around the world may end up destabilising, rather than stabilising, the global economy. We conclude that there may be gains from forging a new conventional wisdom and from encouraging greater monetary policy cooperation.



How do monetary policy spillovers complicate the trade-offs faced by central banks face when responding to commodity prices? This question takes on particular relevance when monetary authorities find it difficult to accurately diagnose the drivers of commodity prices. If monetary authorities misdiagnose commodity price swings as being driven primarily by external supply shocks when they are in fact driven by global demand shocks, this conventional wisdom - to look through the first-round effects of commodity price fluctuations - may no longer be sound policy advice.

To analyse this question, we use the multi-country DSGE model of Nakov and Pescatori (2010) which breaks the global economy down into commodity-exporting and non-commodity-exporting economies. In an otherwise conventional DSGE setup, commodity prices are modelled as endogenously changing with global supply and demand developments, including global monetary policy conditions. This framework allows us to explore the implications of domestic monetary policy decisions when there is a risk of misdiagnosing the drivers of commodity prices. 

The main findings are: i) monetary authorities deliver better economic performance when they are able to accurately identify the source of the shocks, ie global supply and demand shocks driving commodity prices; ii) when they find it difficult to identify the supply and demand shocks, monetary authorities can limit the deterioration in economic performance by targeting core inflation; and iii) the conventional wisdom approach of responding to global commodity price swings (as external supply shocks when they are truly global demand shocks) results in an excessive procyclicality of global inflation, output and commodity prices. In light of recent empirical studies documenting a significant role of global demand in driving commodity prices, we conclude that the systematic misdiagnoses inherent in the conventional wisdom applied at the country level have contributed to destabilising procyclicality at the global level. These findings support calls for greater attention to global factors in domestic monetary policymaking and highlight potential gains from greater monetary policy cooperation focused on accurate diagnoses of domestic and global sources of shocks.

JEL classification: E52, E61

Keywords: commodity prices, monetary policy, spillovers, global economy