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IFDP Notes

September 2013

Do Low Interest Rates Decrease Commodity Price Volatility?

Joseph W. Gruber and Robert J. Vigfusson

Commodity prices have been volatile over the past decade relative to the 1990s. Over the same period interest rates have also been relatively low, suggesting a possible connection.

In our recent working paper, we examine the theoretical and empirical relationship between commodity price volatility and interest rates. In our work, we draw out a new implication of a classic model, showing that lower interest rates should decrease the volatility of commodity prices. While at first glance, this predication may seem at odds with the data, we show that the model can be reconciled with reality after accounting for the persistence of shocks affecting commodity markets.

Lower interest rates should decrease price volatility
Interest rates are an important cost of holding inventories of commodities. When interest rates decline, stockpiling commodities becomes cheaper.  In most economic models (such as elaborated in Deaton and Laroque), inventories work to smooth prices in response to shocks to commodity supply and demand. So, at least in theory, lower interest rates should promote the use of inventories, smooth prices, and decrease price volatility.

There is one important caveat to the theoretical relationship outlined above: inventories are only useful, primarily, for smoothing prices in response to temporary shocks to supply or demand. Permanent or even highly persistent shocks cannot be smoothed and, thus, should directly impact prices with no inventory buffering. As such, low interest rates have no effect on the volatility of prices originating from highly persistent shocks and only temper price movements in response to temporary bumps in supply and demand.

Despite low interest rates, commodity price volatility has increased
As shown in the table below, the volatility of front-month futures prices for a number of commodities has increased significantly in the previous decade. The first column shows the standard deviation of monthly price changes between 1992 and 2002, while the second column reports a similar statistic for 2003 through mid-2012. The third column shows the ratio of these two statistics, with a value greater than one signifying an increase in volatility. For all the commodities considered here, there has been a substantial increase in price volatility.

Table 1
Borrowing Cost Increase Required to Induce Delay or Cutback
(Percent of firms responding)
1 2 3 4 5 6 7 8 9
Front Month Price Year Ahead Futures Price Time Spread (Year Ahead / Front Month)
1992:1 to 2002:12 2003:1 to 2012:7 Ratio 1992:1 to 2002:12 2003:1 to 2012:7 Ratio 1992:1 to 2002:12 2003:1 to 2012:7 Ratio
Crude Oil 0.07 0.08 1.12 0.04 0.07 1.84 0.05 0.04 0.89
Heating Oil 0.07 0.08 1.15 0.04 0.06 1.76 0.05 0.04 0.85
Natural Gas 0.09 0.13 1.40 0.06 0.06 1.08 0.09 0.09 1.00
Aluminum 0.04 0.05 1.26 0.03 0.05 1.62 0.02 0.02 0.83
Copper 0.06 0.07 1.17 0.05 0.08 1.73 0.03 0.02 0.74
Nickel 0.07 0.10 1.41 0.06 0.08 1.35 0.02 0.04 1.86
Zinc 0.05 0.08 1.46 0.03 0.07 2.36 0.04 0.02 0.60

Note: For the Aluminum, Copper, Nickel, and Zinc, year-ahead futures price is the 15-month contract.
Computed as the average conditional standard deviation from a GARCH(1,1) model.
Source: Author's calculations based on aggregated data taken from Bloomberg.

This increase in volatility has occurred despite the very low interest rates that have prevailed over the previous decade, an apparent contradiction of the theoretical model outlined above.  What can explain this contradiction? It is important to remember that interest rates affect the smoothing of temporary shocks but not persistent shocks. So, low interest rates could still be dampening the price volatility coming from temporary shocks, while an independent increase in the volatility of persistent shocks has driven up overall price volatility. Testing this hypothesis requires the identification of temporary and persistent movements in prices. 

The futures curve can be used to distinguish temporary and persistent shocks
Schwartz and Smith (2000) outline how to decompose commodity price movements into permanent and temporary components. Essentially, they assume that the price of the front-month futures contract is affected by both temporary and persistent shocks, while year-ahead prices reflect only persistent shocks. Under these assumptions, movements in the time spread of the futures curve can identify transitory shocks.

Higher price volatility reflects more volatile persistent shocks to commodity supply and demand
Using the methodology of Schwartz and Smith, it becomes clear that the increase in the commodity-price volatility observed over the last decade is the result of an increase in the volatility of persistent shocks, which has more than offset a decline in the contribution of temporary shocks to price volatility.

As shown in the table, year-ahead futures prices (columns 4 and 5) are generally less volatile than front-month futures (columns 1 and 2). However, as shown in column 6, there was a large increase in the volatility of year-ahead futures prices post-2003, with the volatility of year-ahead crude oil contracts increasing over 80 percent over 2003–2012 relative to 1992–2002. In contrast, as shown in column 9, the volatility of the time spread declined in the latter period. Thus, it appears as though for most commodities the increase in the volatility of the front-month contract (shown in column 3) is more than fully explained by an increase in the volatility of persistent shocks, while the volatility of temporary shocks actually declined.

The decline in the volatility due to temporary shocks is, in turn, consistent with the theoretical model’s predictions given the decline in interest rates that has occurred over the past decade. More formally, in our working paper, we estimate a GARCH model to show that the price volatility due to temporary shocks (as identified by movements in the time spread) decreases significantly with an interest rate, particularly for highly storable commodities such as metals and energy products. In contrast, the volatility due to persistent shocks is unaffected by changes in the interest rate.
In conclusion, we find lower interest rates have decreased the volatility of commodity prices in response to temporary shocks, but conclude that increasingly volatile persistent shocks (which are unaffected by interest rates) have boosted measured volatility.

Disclaimer: IFDP Notes are articles in which Board economists offer their own views and present analysis on a range of topics in economics and finance. These articles are shorter and less technically oriented than IFDP Working Papers.

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Last update: September 26, 2013