In February of 1988, Fed Vice Chairman Manuel Johnson confirmed in a speech at the Cato Institute's monetary conference that the Fed was paying more attention to fluctuations in the financial markets—specifically movements in the dollar, commodifies, and interest rate differentials (the yield curve)—in setting monetary policy. A couple of weeks later, Fed Governor Angell added that movements in commodity prices had historically been a good guide to the rate of inflation, not just in the United States but globally as well.
Such admissions by the Fed Governors were significant for a number of reasons. The Fed recognized, in addition to the reliability of commodity markets as a leading indicator of inflation, the importance of the interplay between the various financial markets. The discounting mechanism of the markets was also given the mantle of respectability. The Fed seemed to be viewing the marketplace as the ultimate critic of monetary policy. Fed governors were learning to listen to the markets instead of blaming them. As added confirmation that some Fed members had become avid commodity watchers, the recorded minutes of several Fed meetings included reference to activity in the commodity markets.
Rising commodity prices are associated with an increase in inflation pressures and typically lead to Fed tightening. Falling commodity prices often precede an easier monetary policy. Sometimes activity in the commodity markets make it more difficult for the Fed to pursue its desired monetary goals. During the second half of 1989, the financial community was growing impatient with the Federal Reserve for not driving down interest rates faster to stave off a possible recession.
One of the factors that prevented a more aggressive Fed easing at the end of 1989 was the relative stability in the commodity price level and the fourth quarter rallies in the precious metals and oil markets. To make matters worse, an arctic cold snap in December of 1989 caused oil futures (especially heating oil) to skyrocket and raised fears that early 1990 would see a sharp uptick in the two most widely-watched inflation gauges, the Producer Price Index (PPI) and the Consumer Price Index (CPI). The reasons for those fears, and the main reason the Fed watches commodity prices so closely, is because sooner or later significant changes in the commodity price level translate into changes in the PPI and the CPI, which brings us to the final point in this discussion: The relationship between the CRB Index, the Producer Price Index, and the Consumer Price Index. Read More : COMMODITIES AND FED POLICY
