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VOL. 12, NO. 14 • DECEMBER 2017 DALLASFED

Economic Letter

Demand Shocks Fuel Commodity Booms and Busts

by Martin Stuermer }

ABSTRACT: shocks ooms and busts in commod- avenue of research.2 While the literature due to rapid industrialization ity markets are a particularly on modeling oil markets has examined important part of the global only a handful of boom-and-bust phases have driven commodity price B economy. They affect infla- since the early 1970s, this analysis of booms throughout history. As tion and consumer spending, determine commodity markets is based on a new periods of industrialization lose and welfare in producing dataset of price and output levels for 12 steam and supply catches nations. They also influence growth- agricultural, metal and soft commodities enhancing institutions and may even for the period 1870 to 2013. up, busts follow after about lead to civil unrest. China’s effect on commodity markets 10 years. A new dataset of Understanding which shocks drive is not a new phenomenon. Throughout price and production levels these low-frequency price movements history, demand shocks due to rapid of 12 commodities provides and how long they persist is important in industrialization have driven commodity formulating environmental and resource price booms. evidence of this behavior from policies, for the conduct of macroeco- shocks strongly 1870 to 2013. nomic policy, and, most importantly, for predominate over supply shocks as driv- investment decisions involving extractive ers of price booms across a broad variety and agricultural sectors of the economy. of commodities. Demand shocks strongly Commodity are driven by affect prices for about 10 years, while shocks on the sides. commodity supply shocks impact prices For example, a commodity supply for roughly five years. As periods of is an unexpected decline in crop yield industrialization lose steam and supply due to adverse weather, which shifts catches up, busts follow. Prices return to the supply curve inward and increases their stable or declining trends. prices. An aggregate commodity demand Commodities Dataset Created shock changes the demand for all com- A dataset encompassing global modities at the same time. For example, output and prices for 12 commodities— China’s rapid industrialization led to barley, corn, rice, rye, coffee, cotton, stronger-than-expected increases in the cottonseed, sugar, copper, lead, tin and demand for a broad variety of commodi- zinc—was assembled covering the 143- ties such as copper, oil and wheat over year study period (Chart 1). the past decade.1 The commodity markets selected Thus, examining the effects of shocks exhibit characteristics that make a long- on commodity prices is an intriguing run analysis feasible. Specifically, there Economic Letter

each commodity price. The “aggregate Chart Booms, Busts Not a New Phenomenon demand shock” (for example, unexpect- 1 ed increased in commodity demand due to rapid industrialization) is based on the Annual real price indexes for 12 commodities, 1900 = 100 assumption that this shock can trigger 300 etals Copper Lead Tin Zinc investment and innovation, and subse- quent long-run effects on overall output.3 By comparison, it is assumed that 200 a “commodity ”—such as cartel action or the weather—only affects global (GDP) for a couple of years. This is consistent with 100 evidence that oil supply shocks have had short-lived effects on U.S. GDP.4 Any residual shock—or one that isn’t 0 attributable to an aggregate shock or a 1875 1885 1895 1905 1915 1925 1935 1945 1955 1965 1975 1985 1995 2005 commodity supply shock—is a “com-

modity -specific demand shock.” 300 rains Barley Corn Rice Rye This type of shock is assumed to only affect and poses no long-run effects on global GDP or com- 200 modity production.

Booms, Busts Explained Econometric modeling allows assess- 100 ment of the contribution of each type of shock to commodity prices over time. Chart 2 represents a counterfactual 0 simulation of what the prices of specific 1875 1885 1895 1905 1915 1925 1935 1945 1955 1965 1975 1985 1995 2005 commodities would have been solely in the presence of aggregate commodity 400 Soft Commodities Coffee Cotton Cottonseed Sugar demand shocks. The collective story that emerges 300 suggests that although the proportional contribution of the aggregate commodity demand shocks naturally varies across 200 the different commodities, the accumu- lated effects broadly follow the same pat- 100 tern. Thus, while aggregate commodity demand shocks affect prices to different degrees, they affect the real commodity 0 prices at the same time. These results 1875 1885 1895 1905 1915 1925 1935 1945 1955 1965 1975 1985 1995 2005 then suggest that aggregate commodity SOURCE: “What Drives Commodity Booms and Busts?” by David Jacks and Martin Stuermer, Bank of Dallas Working Paper no. 1614, November 2016. demand shocks have a common source. This interpretation of aggregate com- is longstanding evidence of an integrated supply or demand curves of a commod- modity demand shocks is in line with world market; there is no strong indica- ity market. An underlying idea is that what suggests about tion of sudden change in how the com- firms do not anticipate these shocks. global output fluctuations. Historical modity is used, and there is a high degree Because it’s not easy for supply or decompositions start in 1875, when pric- of product homogeneity. Thus, the 12 demand to fully respond, there are either es were depressed due to the negative commodities selected have long-term supply shortfalls or oversupply, leading accumulated effects of aggregate com- characteristics that mineral commodities to price increases or decreases as firms modity demand shocks on prices during such as iron ore or crude oil only gained discover they are either underinvested or the first—but somewhat forgotten—Great relatively recently. overinvested. Depression. The econometric model employed The effects of subsequent aggregate Identifying Price Shocks here allows identification of the con- commodity demand shocks are in line Shocks are unexpected shifts in the tribution of three types of shocks to with historical occurrences of business

2 Economic Letter • Federal Reserve Bank of Dallas • December 2017 Economic Letter cycles in major economies. For example, ther to 16 percent in the period after persistent, with effects lingering up to the effects of the large negative aggregate World War II. 10 years. Commodity market-specific commodity demand shock in 1907 can At the same time, the average share demand shocks are slightly less persis- be associated to the so-called Panic of of aggregate commodity demand shocks tent but with effects also lasting up to 10 1907. Likewise, in the early 1930s, real has increased from 29 percent in the pre- years in some cases. Finally, effects of prices plummeted as the (second) Great World War I period to 34 percent during commodity supply shocks, for the most Depression reduced global demand for the and up to 38 percent part, are insignificant. The sugar and tin commodities. in the post-World War II period. markets are exceptions to this generality, After World War II, positive aggre- On average, the effects of aggregate with significant effects lasting up to five gate commodity demand shocks led to commodity demand shocks are the most years. increases in real commodity prices as re-industrialization and re-urbanization in much of Europe and Japan proceeded, Chart followed by of Commodity Prices React to Demand Shocks Simultaneously the East Asian Tigers (following Japan’s 2 lead). Annual real price indexes for 12 commodities, 1900 = 100 Negative aggregate commodity 1.0 rains demand shocks are evident in the late Rye Barley Corn Rice 1970s, the early 1980s and the late 1990s, respectively corresponding to the global 0.5 of 1974 and 1981 and the Asian of 1997. These are 0 followed by a series of positive aggregate commodity demand shocks emerging from the late 1990s and early 2000s due –0.5 to unexpectedly strong global growth, driven by the industrialization and –1.0 urbanization of China. 1875 1885 1895 1905 1915 1925 1935 1945 1955 1965 1975 1985 1995 2005 Finally, the lingering effects of the global financial crisis are also clearly 1.0 Soft Commodities Coffee Cottonseed Sugar Cotton visible.

Demand Dominates Supply 0.5 From 1871 to 2013, aggregate com- modity demand shocks explained 32–38 0 percent of the variation in real commod- ity prices (across the three types of com- –0.5 modities examined here), while com- modity market-specific demand shocks explained 42–50 percent (Table 1A). –1.0 These two types of shocks, thus, caused 1875 1885 1895 1905 1915 1925 1935 1945 1955 1965 1975 1985 1995 2005 an appreciable portion—74–88 percent— 1.0 of medium- and long-run fluctuations in etals Lead Copper Tin Zinc 0.8 real commodity prices. 0.6 Conversely, commodity supply 0.4 shocks played a rather secondary and 0.2 transient role, explaining only 18–20 per- 0 cent of the variation. This result is fairly –0.2 consistent across agricultural, mineral –0.4 and soft commodities. –0.6 Averages for three subperiods based on the full sample (Table 1B–D) show –0.8 that commodity supply shocks have lost –1.0 1875 1885 1895 1905 1915 1925 1935 1945 1955 1965 1975 1985 1995 2005 importance over time, as their average share declined from 24 percent in the NOTE: Charts show a counterfactual simulation of what the prices of specific commodities would have been solely in the presence of aggregate commodity demand shocks. period before World War I to 23 percent SOURCE: “What Drives Commodity Booms and Busts?” by David Jacks and Martin Stuermer, Federal Reserve Bank of during the interwar period and fell fur- Dallas Working Paper no. 1614, November 2016.

Economic Letter • Federal Reserve Bank of Dallas • December 2017 3 Economic Letter

tions of real commodity prices over a Table long period of time. Different Types of Shocks Explain Commodity Price Booms, Busts 1 The results suggest that the price effects of the large commodity demand Percentage share of each type of shock that explains commodity price fluctuations shocks attributable to China in 2003–07 A: 1871–2013 and 2009–11 will dissipate. In the Aggregate commodity Commodity Commodity absence of additional positive commodi- demand shock supply shock market-specific demand shock ty demand shocks, it appears that current Grains 32 18 50 prices may stay low while abundant sup- Metals 38 20 42 plies are consumed. Commodity export- Softs 34 20 44 ers should, thus, prepare for a prolonged Total 35 20 46 period of depressed commodity prices.

B: 1871–1913 Stuermer is a research in the Aggregate commodity Commodity Commodity demand shock supply shock market-specific demand shock Research Department at the Federal Re- Grains 26 23 52 serve Bank of Dallas. Metals 33 24 44 Softs 27 24 48 Notes 1 See “Industrialization and the Demand for Mineral Total 29 24 47 Commodities” by Martin Stuermer, Journal of Interna- C: 1919–39 tional and Finance, vol. 76, 2017, pp. 16-27, Aggregate commodity Commodity Commodity for an empirical exploration of the relationship between demand shock supply shock market-specific demand shock industrialization and mineral commodities. Grains 32 19 49 2 For details on the data, methodology and results, see Metals 34 27 38 “150 Years of Boom and Bust: What Drives Mineral Softs 35 19 46 Commodity Prices?” by Martin Stuermer, Macroeconom- Total 34 23 45 ic Dynamics, 2018, forthcoming, and “What Drives Com- D: 1949–2013 modity Booms and Busts?” by David Jacks and Martin Aggregate commodity Commodity Commodity Stuermer, Federal Reserve Bank of Dallas Working Paper demand shock supply shock market-specific demand shock no. 1614, December 2016. Grains 37 16 47 3 For each commodity market, a Structural Vector Metals 42 16 42 Autoregressive Model with long-run restrictions is used. Softs 38 18 45 It includes three endogenous variables—global gross

Total 38 16 46 domestic product (%), global commodity production (%) and world commodity price (ln). The model also controls SOURCE: “What Drives Commodity Booms and Busts?” by David Jacks and Martin Stuermer, Federal Reserve Bank of Dallas Working Paper no. 1614, November 2016. for constant, linear trends and the world war periods. 4 See “Not All Oil Price Shocks Are Alike: Disentangling Persistent, Low Prices commodity demand shocks and com- Demand and Supply Shocks in the Crude Oil Market,” by After examining the drivers of real modity market-specific demand shocks Lutz Kilian, American Economic Review, vol. 99, no. 3, commodity prices in the long run among appear to strongly dominate over com- June 2009, pp. 1053–69. different types of commodities, aggregate modity supply shocks in driving fluctua-

DALLASFED Economic Letter Marc P. Giannoni, Senior Vice President and Director of Research is published by the Federal Reserve Bank of Dallas. Jim Dolmas, Executive Editor The views expressed are those of the authors and Michael Weiss, Editor should not be attributed to the Federal Reserve Bank Dianne Tunnell, Associate Editor of Dallas or the Federal Reserve System. Ellah Piña, Graphic Designer Articles may be reprinted on the condition that the source is credited to the Federal Reserve Bank of Dallas. Economic Letter is available on the Dallas Fed website, www.dallasfed.org. Federal Reserve Bank of Dallas 2200 N. Pearl St., Dallas, TX 75201