Interest Rates and the Volatility and Correlation of Commodity Prices

32 Pages Posted: 9 Jan 2013

See all articles by Joseph W. Gruber

Joseph W. Gruber

Board of Governors of the Federal Reserve System

Robert J. Vigfusson

Board of Governors of the Federal Reserve System

Date Written: November 13, 2012

Abstract

We purpose a novel explanation for the observed increase in the correlation of commodity prices over the past decade. In contrast to theories that rely on the increased influence of financial speculators, we show that price correlation can increase as a result of a decline in the interest rate. More generally, we examine the effect of interest rates on the volatility and correlation of commodity prices, theoretically through the framework of Deaton and Laroque (1992) and empirically via a panel GARCH model. In theory, we show that lower interest rates decrease the volatility of prices, as lower inventory costs promote the smoothing of transient shocks, and can increase price correlation if common shocks are more persistent than idiosyncratic shocks. Empirically, as predicted by theory, we find that price volatility attributable to transitory shocks declines with interest rates, while, for many commodity pairs, price correlation increases as interest rates decline.

Keywords: Commodity storage, panel GARCH, dynamic factor model

JEL Classification: Q00, G12

Suggested Citation

Gruber, Joseph W. and Vigfusson, Robert John, Interest Rates and the Volatility and Correlation of Commodity Prices (November 13, 2012). FRB International Finance Discussion Paper No. 1065, Available at SSRN: https://ssrn.com/abstract=2196436 or http://dx.doi.org/10.2139/ssrn.2196436

Joseph W. Gruber (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Robert John Vigfusson

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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