Interest Rates and the Volatility and Correlation of Commodity Prices

Abstract

We purpose a novel explanation for the observed increase in the correlation of commodity prices over the past decade. In contrast to theories that rely on the increased influence of financial speculators, we show that price correlation can increase as a result of a decline in the interest rate. More generally, we examine the effect of interest rates on the volatility and correlation of commodity prices, theoretically through the framework of Deaton and Laroque (1992) and empirically via a panel GARCH model. In theory, we show that lower interest rates decrease the volatility of prices, as lower inventory costs promote the smoothing of transient shocks, and can increase price correlation if common shocks are more persistent than idiosyncratic shocks. Empirically, as predicted by theory, we find that price volatility attributable to transitory shocks declines with interest rates, while, for many commodity pairs, price correlation increases as interest rates decline.