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The fall of raw materials and energy prices: Implications in calculating the CPI

Updated: Dec 4, 2023

Behavior of commodities in the phases of the economic cycle and a total overview of the current situation

With commodity prices at all time high in the last period, spreading panic in industries, consumers, and politicians, we should ask ourselves whether the commodities’ prices behavior is totally depending on the flow of the economic cycle, or we should fear a major economic downfall.

In the 1930s, Nicholas Kaldor analyzed commodity prices and their behavior over the business cycle, developing what’s known as the cobweb theorem, explaining fluctuations in the demand-supply market of raw materials. It is an economic model used to explain how small economic shocks can become amplified by the behavior of producers. This amplification is the result of information failure, where producers base their current output on the average price that they obtain in the market during the previous year. This is, to some extent, a non-rational decision, given that a supply side shock between planting and harvesting can lead to an unexpectedly lower or higher price. This results in either a higher output or a lower output in subsequent years and moves the market into a long-term disequilibrium position.

This is what would happen in a usual economic cycle. Needless to say, the events of the last years such as the pandemic or war in Ukraine altered the normal course of events. The increase in energy prices over the past two years has been the largest since the 1973 oil crisis. Price increases for food commodities -of which Russia and Ukraine are large producers- and fertilizers, which rely on natural gas as a production input, have been the largest since 2008.

“These developments have started to raise the specter of stagflation. Policymakers should take every opportunity to increase economic growth at home and avoid actions that will bring harm to the global economy.” Indermit Gill, the World Bank’s Vice President for Equitable Growth, Finance, and Institutions.

The continuous increase of prices is not expected to stop before 2024: wheat prices are forecast to increase more than 40 percent, reaching an all-time high in nominal terms this year. That will put pressure on developing economies that rely on wheat imports, especially from Russia and Ukraine. Metal prices are projected to increase by 16 percent before easing at the end of 2023 but will remain at elevated levels. This long-lasting effect will lead to a reduction of production especially in the food industry, affecting availability, quality and of course quantity, while weighting on already poor countries. The overall effect on the global economy will be a long-lasting period of inflation.

Behavior of gold in the phases of the economic cycle and a total overview of the current situation

Gold has always been an important store of value in every historical era and in every part of the world. Its intrinsic value and relative stability make it an attractive option for investors seeking to protect their capital during periods of economic turmoil. In this article, we will look at how gold performs during different economic phases and give an overview of the current situation. During economic expansion, gold tends to lose value as investors prefer to invest in riskier assets, such as stocks.

During this period, economic activities are growing, companies are earning profits and investor confidence is high. This means that gold, which is considered a safe heaven asset, becomes less attractive. However, there are exceptions to this rule. For example, during the gold rush in the 1980s, the price of gold rose along with the global economic expansion.

In times of recession, on the other hand, gold becomes very popular. During these periods, investor confidence declines and risky investments become less attractive. Moreover, in a recession, currencies may lose value and inflation may rise, which makes gold a more attractive option. This is especially true when central banks implement expansionary monetary policies, such as money printing, to stimulate the economy. In these situations, gold can be used as protection against inflation and as a store of value.In times of economic stagnation, gold can be an attractive option. Economic stagnation occurs when the economy either grows or declines and unemployment is high. In these periods, gold can be used as a protection against the loss of value of currencies.

In general, gold is considered a safe haven asset in times of economic and political uncertainty. This is why gold has been very popular in recent years, particularly during the 2008 financial crisis and the COVID-19 pandemic. During these periods, investors tried to protect their capital by investing in gold.

Currently, the price of gold is on the rise. This is due to a number of factors, including the economic uncertainty caused by the COVID-19 pandemic, rising inflation and the expansive monetary policies of central banks. In addition, rising interest rates could make gold an even more attractive option for investors.

In conclusion, gold is an attractive option for investors in times of economic and political uncertainty. Its intrinsic value and relative stability make it an attractive option for investors seeking to protect their capital.

Impact of raw materials in the calculation of the CPI and forecast of the next readings

To begin this analysis we will start from the study of the basket for calculating the American CPI in its internal categories and their impact on the final figure.

How is CPI built?

The Bureau of Labor Statistics (BLS) or the body responsible for calculating the CPI, calculates the CPI as a weighted average of prices for a basket of goods and services representative of aggregate U.S. 2 consumer spending by collecting around 80,000 prices each month from around 23,000 shops and services.

Obviously each category of good or service has a percentage of weight in the calculation based on the estimated average use of a citizen, these are the current percentages.

How is CPI calculated?

We won't dwell too much on this point, for the purposes of this article it is enough to know that for the calculation of the annual CPI the data of the same period of the past year are compared and a proportion is developed on the change of the latter. I recommend reading this article if you want to learn more about "How To Calculate CPI".

How much do commodities impact on CPI?

We finally come to the heart of the matter, as seen previously, the percentage impact of raw materials on the CPI is calculated with a weight of 12.9%, immediately after transport and food as well as obviously housing, the main category with 34.4%. This shows us how the raw materials part has a significant impact on the final CPI figure, but also shows us how it is not the only creator. So why lately do we always tend to blame the increase in raw materials as the main cause of the CPI explosion?

This is due to the fact that the commodities category can only be considered as the "direct" part of the impact of raw materials on inflation. In addition to that, we have a whole part of "indirect" effects which is responsible for the increase, for example, in the food and transport categories.

What correlation do we have between raw materials and CPI?

In the following graph I have related the bloomberg commodity index (blue line), which as you can easily guess is an index that takes into consideration a set of raw materials and shows their movements and the American CPI indicator, is what emerges clearly is a strong relationship due, as mentioned before, to the large impact of raw materials on the cost of living.

What can we expect from the next CPI readings? Always assuming the fact that I don't consider myself a seer and that therefore I don't have the possibilities to see the future, there is no doubt that for some time now we have entered a period of economic contraction mainly due to the rise in interest rates. This will most likely lead to a decline in raw materials and consequently to an absorption of inflation. However, let us take into consideration the variable China, which at any moment could restart its economy at full capacity and consequently we could see a new rise in raw materials and consequently in inflation, a move that the FED would be forced to raise the target level of interest rates once again.


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