South African Reserve Bank

Note on the interrelationship between commodity prices, the

exchange rate and domestic prices
by M Kock1

This note briefly reviews the interrelationships between commodity prices, the exchange 1 The views expressed are
those of the author and do not
rate and domestic inflation. It updates and extends the analysis of the international necessarily reflect the views of
commodity prices boom and its impact on the South African economy which was the South African Reserve Bank.

presented as a box on “Commodity prices in South Africa” in the November 2004

Monetary Policy Review.

There are various barometers of commodity prices.2 However, there tends to be a 2 The Economist all-items
commodity price index includes
considerable degree of correlation between these prices, since some of the drivers of food and industrial commodities
international commodity prices, such as the strength of global demand, are felt across with the latter comprising of
non-food agriculturals and
all commodities. The most relevant commodity price indicator for South African exports metals. The Commodity
Research Bureau (CRB) indices
is the price index compiled by the South African Reserve Bank which uses weights are sourced from
based on the importance of the various commodities in the South African “export http://www.crbtrader.com. The
Reuters/Jefferies CRB Index is a
basket”. The fairly strong correlation between this index and other frequently used benchmark for long-only broadly
commodity price indices is illustrated in the accompanying graph. Although it seems that diversified investments in
commodities. For more
the conclusions of the analysis would broadly hold irrespective of which measure is information see Jefferies.com.
The CRB Spot Index is a
used, there are some notable divergences which are especially evident during the period measure of price movements of
1994 to 1999. twenty-two basic commodities
assumed to be those that are
first to be influenced by changes
in economic conditions. The
Reuters CRB Index serves as a
dynamic representation of
Commodity prices overall broad trends in
commodity prices.
Indices: 2000=100
200
180 Denominated in US dollar

160
140
120
100
80
200
180 Denominated in rand

160
140
120
100
80
60
40
20
1991 1993 1995 1997 1999 2001 2003 2005

All-items commodity price index (Source: The Economist)

Reuters/Jefferies CRB Index (Source: I-net Bridge)
Reuters CRB Index (Source: Commodity Research Bureau)
CRB Spot Index (Source: Commodity Research Bureau)
South African commodity prices (Source: SARB)

Quarterly Bulletin December 2006 61

South African Reserve Bank

While South Africa’s exports have become increasingly diversified over time, commodities
continue to be a major contributor to export earnings. Changes in commodity prices
accordingly have a significant impact on the foreign-exchange value of the rand, not only
through the resultant changes in the supply of foreign currency flowing into the market
but also more immediately through expectations based on the observed spot prices of
commodities. This is illustrated in the accompanying graph, which for instance shows
that in 2001 a decline in commodity prices was accompanied by, and probably
exacerbated, rand depreciation. However, other forces were at work at the same time. It
should be pointed out that the relationship is far from perfect, and that movements in
both the US dollar prices of commodities and the exchange value of the rand against the
dollar may on occasion simply reflect strength or weakness of the dollar against
currencies in general.

South African export commodity prices and the exchange rate

Percentage change over twelve months
70
60
50
40
30
20
10
0
-10
-20
-30
-40
1992 1994 1996 1998 2000 2002 2004 2006
South African commodity prices in US dollar terms (Source: SARB)
Rand/US$ exchange rate (rand depreciation +, appreciation -)

From May 2006 in particular, the exchange value of the rand depreciated significantly
while the commodity prices relevant to South Africa receded somewhat. As of late, the
exchange value of the rand recorded year-on-year rates of depreciation of 16,5 per cent
in September and 16,3 per cent in October 2006.

South African export commodity prices therefore constitutes one of the determinants of
the exchange value of the rand, and in this way feeds into the inflation process.
Observing this channel, one would expect higher commodity prices in dollar to be
associated with a stronger rand and lower inflation. However, there is also a cost-push
channel through which commodity prices affect domestic inflation. In this instance,
however, it is not the prices of South African export commodities that are relevant, but
rather a broader measure of international price pressures. Furthermore, the analysis
should be based on commodity prices denominated in rand terms as the relevant
currency for valuing input cost in the South African industry that will be reflected in
domestic producer price inflation and CPIX goods inflation. In this connection The
Economist all-items commodity dollar index converted from US dollar to rand at the
average US$/rand exchange rate was used.

62 Quarterly Bulletin December 2006

 South African Reserve Bank

Commodity prices and domestic inflation

Percentage change over twelve months
70 20
60
50
40 15

30
20
10
10
0
-10 5
-20
-30
-40 0
1990 1992 1994 1996 1998 2000 2002 2004 2006
All-items commodity price index in rand terms (Source: The Economist)
Production prices of domestically produced goods (right-hand scale)
CPIX goods prices (right-hand scale)

The graph above indicates that The Economist commodity price index in rand terms 3 CPIX is the overall
consumer price index,
tends to be a leading indicator of domestic production price inflation which, in turn, spills excluding interest rates on
over into CPIX3 goods price inflation. mortgage bonds, for
metropolitan and other urban
areas. CPIX only became
available from 1998. Before
Since May 2006 the weakening of the exchange value of the rand has pushed that, the CPI goods price index
commodity prices in rand terms higher. As in 2001 and 2002, domestic production and was used.

CPIX goods price inflation have responded by accelerating significantly.

Inflation is a complex process involving the interaction between numerous variables. Any
analysis which narrows it to only two or three variables is clearly oversimplified, but at
the same time it can be extremely helpful by capturing and illustrating at least some of
the key drivers of price pressures. In this spirit, the analysis in this note indicates that
commodity prices in rand terms are a leading indicator of domestic production price
inflation and CPIX goods price inflation.

Quarterly Bulletin December 2006 63