Thomas Morrison and Michael Wattleworth
In spite of the world economic recovery following the recession of 1981-82, a troubling development for most developing countries was the steep and broad-based decline in primary commodity prices that occurred from mid-1984 to 1986 (see “The Sharp Fall in Commodity Prices, 1984-86,” December 1986). Economic growth in the industrial countries continued, though at a slower pace. Yet nonfuel primary commodity prices in real terms fell to their lowest levels since the 1930s. The occurrence of such a decline in commodity prices during the upswing of the business cycle has raised concerns about the nature and causes of the decline, particularly as to whether it resulted more from structural factors than from short-term temporary factors, and about the implications of this decline for the economic prospects of developing countries.
The 1984-86 commodity recession seriously affected the growth of developing countries that depend heavily on exports of primary commodities. This article and the accompanying charts analyze the underlying causes of this decline in commodity prices.
After reaching their trough in the fourth quarter of 1982, commodity prices began to recover in the first quarter of 1983 in tandem with the growth of economic activity in the industrial countries (see Chart 1). This recovery continued until the second quarter of 1984 when prices were about 20 percent higher in dollar terms than in the last quarter of 1982. All commodity groups participated in this recovery, with the prices of food and beverages advancing the most and those of metals the least (see Chart 2). Then, commodity prices started their steep decline, breaking their earlier rather close positive relationship with economic activity in industrial countries.
Commodity prices in US dollar terms fell by a cumulative 26 percent from mid-1984 to the third quarter of 1986. Food prices fell the most (by 35 percent), followed by the prices of agricultural raw materials (25 percent), metals (17 percent), and beverages (5 percent). The only group whose prices did not continue to fall over this two-year period was beverages. Prices of beverages declined until the end of 1985, when they increased sharply in response to the impact of a drought in Brazil on coffee prices. By the third quarter of 1986, nominal commodity prices in terms of the US dollar had fallen to their lowest level since 1976.
Real commodity prices (that is, nominal prices deflated by the prices of manufactured exports of industrial countries) declined even more sharply, falling by a cumulative 36 percent from the second quarter of 1984 to the third quarter of 1986. During the last three decades, such large declines in real commodity prices were only experienced in the 1975 recession, and that decline from a major price boom in 1973-74 was followed quickly by a fairly strong recovery in 1976.
Commodity prices began to recover in 1987, but it is too soon to say whether this is the beginning of a major upward swing.
The cumulative price decline in 1984-86 was larger and longer than the four previous declines since 1970. From the beginning of the 1970s, the amplitude of commodity price cycles has increased substantially (Chart 3). However, it is the length of the most recent decline, rather than its pace, that has made it particularly severe.
Analyzing the decline
Two theoretical models were adapted in order to explain the 1984-86 decline in commodity prices (see box). One explained, relatively simply, commodity prices on the basis of readily available quarterly data on certain demand variables and a rough approximation of supply shocks. The second, somewhat more complex, model integrated the supply-side in a more rigorous way by taking into account the influence of short-term supply changes as well as the medium-term interaction between production capacity and prices. This model relied on annual data, and on somewhat imperfect measures of supply changes. Both models were used to produce likely patterns of commodity price behavior during the decline and recovery phases of individual price cycles.
This article is based on a longer paper, available from the authors. The analytical structure of the models used for the analysis in the article is described in two papers by Ke-Young Chu and Thomas K. Morrison: “The 1981-82 Recession and Non-Oil Primary Commodity Prices, “ Staff Papers, International Monetary Fund (Washington), March 1984; and “World Non-Oil Primary Commodity Markets: A Medium-Term Framework of Analysis, “ Staff Papers, IMF, March 1986.
The effectiveness of the models was measured by comparing their predictions of commodity price behavior with actual price movements. Based on the results produced by these two models, it was possible to see which factors best explained the decline in commodity prices during 1984-86. Both models were used to understand the 1984-86 commodity price decline because each provided particular insights. While there were trade-offs between empirical precision and theoretical completeness in both cases, the first model was superior because of its ability to track price cycles on a quarterly basis, while the second model’s elaboration of the supply-side was an advantage. Together the results of these models demonstrated in a rather striking way the relatively greater importance of supply factors in the 1984-86 commodity price decline in comparison with previous cycles.
Demand-oriented model. This model was quite good in predicting the phases of the four cycles from 1970 to 1984, correctly predicting seven of the eight phases.
The dominant variable explaining commodity price movements in the three cycles in the 1970s was economic activity in the industrial countries, which was much more unstable than during the previous decade. Inflation also accelerated substantially and was a major factor influencing commodity prices, especially during the recovery phases of the three cycles. Even during the “commodity price boom” of 1972-74, when speculative forces and special supply factors were thought to have exerted significant influence, economic activity and inflation together contributed to a large part of the price increase. Movements in the US dollar exchange rate did not contribute substantially to commodity price movements until the recovery phase of the 1977-80 cycle when the depreciation of the US dollar put upward pressure on commodity prices expressed in US dollars.
The 1980-84 cycle was somewhat different from the three cycles in the 1970s. Although economic activity continued to exert a major influence on commodity prices, the influence of inflation moderated considerably while that of the US dollar exchange rate increased. Indeed, the strong appreciation of the dollar during 1981-82 made the largest contribution to the sharp decline in commodity prices during this period. Its effects were accentuated by the decline in economic activity associated with the recession. The main contributor to the recovery phase of this cycle was again the rise in economic activity during 1983 and the first half of 1984.
Given the good performance of the quarterly demand-driven model in predicting commodity price movements over the previous four cycles, the large prediction error for the period mid-1984 to 1986 becomes all the more noteworthy. The model predicted an increase in commodity prices over this period of 4 percent, while actual commodity prices showed a decline of 26 percent. Economic activity, although decelerating from an annualized rate of 6 percent during the 1983-84 recovery to 2 percent, still had a positive influence on commodity prices. Inflation, while similarly decelerating from an annualized rate of 7 percent during 1983-84 to 2 percent, also made a small but positive contribution. Perhaps the most unexpected development was that the large depreciation of the US dollar did not appear to be reflected in actual commodity price movements.
Chart 1Non-oil commodity prices and industrial production, 1970-87
Citation: 25, 2; 10.5089/9781616353735.022.A010
Chart 2Commodity price movements, 1083-87
Citation: 25, 2; 10.5089/9781616353735.022.A010
Chart 3Non-oil commodity prices 1959—88: percentage deviations from a five-year moving average
Source: International Financial Statistics, IMF.
Chart 4Commodity price cycles, actual and predicted from demand-supply model, 1980-86
Citation: 25, 2; 10.5089/9781616353735.022.A010
The poor performance of the quarterly demand-oriented model in predicting the price decline phase of the current cycle, in the face of its rather consistently good performance over the four previous cycles, clearly suggested that important supply factors not included in this model and unique to the current cycle were influencing commodity prices. This possibility was explored by the second model.
The demand and supply model. This analysis took into account, in addition to demand-side factors, annual changes in current supplies of food and beverages and changes in the production capacity of agricultural raw materials and metals. The use of the annual data meant the loss of some of the precision of the first, quarterly, model in analyzing developments during the phases of a cycle. Thus, it was not possible to track the commodity price cycles since 1970 with the annual data, as was possible with the quarterly data of the demand-side model. Nevertheless, predictions on an annual basis still permitted an analysis of the weakness in commodity prices during 1984-86.
Unlike the quarterly demand-side model, which predicted a continuing but decelerating recovery in prices over 1984-86, the annual demand and supply model predicted the beginning of a new cycle in 1984-85 with overall commodity prices declining by 1.9 percent in 1984 and by 6.6 percent in 1985 (Chart 4). The main factor contributing to this predicted two-year price decline was the concurrent substantial increase in world food supplies, the largest two-year increase since 1960. This large supply increase reflected, in turn, favorable growing conditions in major producing areas, lagged supply responses to earlier price increases, and price-support policies in some industrial countries that continued to encourage agricultural production in the face of decelerating demand. In addition, lagged responses in the production capacity of industrial raw materials to high prices of the late 1970s and early 1980s contributed to the weakness in the prices of these commodities, particularly agricultural raw materials, in the mid-1980s. Demand growth in the annual model, as in the quarterly model, contributed positively to commodity prices during 1984—86, but was insufficient to offset the negative long-term trend in commodity prices. It was estimated that demand would need to grow by over 3 percent per year to offset the negative long-term trend.
The extent of the actual decline was underpredicted by a wide margin, suggesting that structural factors, which depress prices and which are difficult to quantify, may have intensified. During the 1980s, for example, industrial countries shifted production away from the use of commodities toward lighter and new materials. However, since the model predicted fairly well the weakness in commodity prices throughout the 1980s, the underprediction of the 1984-86 price decline may be due also to the difficulty of getting complete and current annual data, or to special factors. The weakness in metal prices, most frequently affected by the structural factors mentioned above, was fairly well predicted by the model in the 1980s.
The main source of the underprediction of the 1984-86 commodity price decline was the behavior of prices of food commodities in 1986, which (at 43 percent) have the largest weight in the total commodity basket. While food prices were predicted to increase by 9.7 percent in 1986, they in fact declined by 13.9 percent. Although the model took into account a continuation of the strong negative impact of supply-side factors on food prices, its overall prediction of a good price recovery in 1986 was based on the strong positive contribution from the large depreciation of the US dollar. Two somewhat related reasons may help to explain the prediction error for 1986. First, the enactment of the US Farm Bill (not captured by the model) at the beginning of 1986 put downward pressure on global food prices. This change in agricultural policy of the world’s largest food exporting country significantly lowered support prices (e.g., by about 25 percent for cereals), and resulted in greater supplies for export being made available to the market at sharply lower prices. Second, partly because of the US Farm Bill and as a result of the cumulative effects of several years of large world food production, price competition in food export markets intensified significantly in 1986. This too helped lower prices and largely negated the positive contribution of the depreciation of the US dollar.
The results of the analysis of commodity prices showed that rising supplies of food and larger production capacity of agricultural raw materials and metals were the major factors depressing primary commodity markets in the 1980s and particularly in 1984-86. Relatively low economic growth in the industrial countries was another factor. Economic growth in the industrial countries would have to be over 3 percent per year to negate the downward pressures of long-term structural changes in the demand and supply of commodities.
The implications of this analysis for the commodity price outlook in the short- and medium-term are somewhat encouraging for commodity producers, in the sense that much of the decline in commodity prices in 1984—86 can be explained by supply and demand factors that are reversible, rather than by long-term structural and irreversible factors. The reversal of these factors, however, depends largely on developments in the industrial countries, where the growth outlook is perhaps not very encouraging. Economic growth in the industrial countries in the 1980s, generally below 3 percent per year, appears likely to remain sluggish in light of current estimates of expansion in potential output.
A significant recovery in commodity prices, therefore, will probably depend largely on a reversal of the oversupply and excess production capacity that have characterized commodity markets in recent years. Agricultural policies in industrial countries would have to continue along the trend begun in 1986 toward lower producer prices to better reflect world prices, and it would be necessary to avoid a premature activation of idle production capacity for metals, again mostly in industrial countries. While it may appear unusual to say that a recovery in commodity prices depends on controls against oversupply, our research showed that the downturn in commodity prices in 1984-86 was also unusual in that it was caused largely by supply factors. Finally, it is possible that the lagged effects of the large depreciation of the US dollar in recent years will contribute to higher commodity prices in US dollar terms.