Volatile commodity prices reduce growth and amplify swings in inflation

Food and energy prices surged to near historic highs in recent years amid the pandemic and the war in Ukraine, which prompted major supply disruptions. This was accompanied by a sharp rise in the volatility of commodity prices as well.

Worryingly, the up-and-down swings in commodity prices will likely pose economic challenges in coming years. We explore the effects of volatile commodity prices in a new report on food and energy insecurity that was prepared for the Group of Twenty.

Specifically, we examine how economic growth and inflation are affected by volatility in commodity terms of trade—that is, the movement in the prices that a country pays for commodity imports and the prices it receives for commodity exports.

Such swings in commodity prices can weigh on long-term economic growth, especially for commodity exporters. For example, higher volatility in commodity prices may induce greater volatility in government finances in commodity exporting countries and thereby lead to stop-start public investment. In turn, this would weigh on both physical and human capital investment.

Commodity price swings

Volatile commodity terms of trade (CToT) will affect economies for years.

Source: Gruss and Kebhaj (2019), and IMF staff calculations. • Note: The left panel shows the average over the indicated time periods of the standard deviation of year-on-year growth rates of the CToT, which has increased since 2019 to be well above its long-run average, in a sample of 182 countries. The right panel shows the estimated effect of increasing CToT volatility by 1 percent on per capita income growth and on inflation volatility. These effects are derived from regressions of per capita income growth and of inflation volatility on CToT volatility and additional controls.

What's more, volatility in commodity prices also appears to increase the volatility of domestic inflation over the medium term. This can occur, for example, as greater volatility in the price of imported goods passes through to domestic prices and thereby result in more volatile consumer inflation.

The challenges from heightened commodity price volatility come on top of the problems caused by the surge in price levels. World food commodity prices rose nearly 40 percent in the two years just before Russia's invasion of Ukraine, and the war propelled prices even higher. Wheat prices jumped 38 percent in March 2022 from a month earlier. Energy prices rose sharply, with natural gas prices in Europe tripling. High energy prices also fed into record prices of commonly used fertilisers for food production.

Slow return

Energy and food prices remain elevated even after moderating.

Source: Haver Analytics; IMF, Primary Commodity Price System Database; IMF, World Economic Outlook; and IMF staff calculations. • Note: Dotted vertical line marks Russia's invasion of Ukraine.

While international food and energy prices have moderated since their recent peak, they nonetheless remain elevated. Moreover, the surge has contributed to higher consumer prices and led to economic hardship across the globe. Millions of people, especially in poorer countries, are being pushed into food insecurity.

The World Food Programme estimates that 345 million people in almost 80 countries will face acute food insecurity this year—more than double the number in 2020.

Amid these challenges, policymakers must remain vigilant.

First and foremost, addressing inflation is a key concern, which means that monetary policy must remain focused on bringing inflation down. At the same time, fiscal policy should aim for gradual and steady tightening, and thus reduce the pressure on monetary policy to combat high inflation, while supporting the most vulnerable. As such, costly broad-based policies to mitigate the impact of higher commodity prices, including measures like price subsidies to limit the pass-through to domestic prices, need to be unwound and replaced by targeted measures to support vulnerable households.

Such actions would help avoid distortions that would prevent or delay adjustments to higher energy prices. In addition, they would preserve incentives for development of alternative green energy sources, and support fiscal sustainability. This would also have beneficial distributional effects, as energy subsidies tend to also benefit richer households. To minimise longer-lasting adverse effects of volatility in commodity prices, it is also important to ensure strong macro-fiscal institutions that can buffer commodity price volatility.

And domestic actions must not stand alone. Multilateral efforts are essential in achieving shared objectives of addressing food and energy insecurity. It is vital to sustain open trade in food. Moreover, free flow of trade in metal and mineral inputs that are critical for the green transition would also support energy security.

Disclaimer: This article first appeared on IMF blog