A factor model of commodity price co-movements: An application to New Zealand export prices
An important focus for the Reserve Bank of New Zealand as a central bank of a small commodity exporting country is to understand movements in commodity prices and their flow through to incomes, real economic activity and inflation. Idiosyncratic movements in New Zealand export prices can have different implications for terms of trade and incomes compared to a generalised movement in all commodity prices. Therefore, a framework that can help distinguish between general and idiosyncratic movements in commodity prices can help shed some light on the implications for the New Zealand economy of movements in export commodity prices.
In this analytical note, we use principal component analysis to estimate the underlying global trend in commodity prices and then determine whether movements in New Zealand dairy and meat export prices can be explained by the global trend in commodity prices or by idiosyncratic events in each market. Using commodity price data from 1986, we find that 95 and 93 percent of the volatility of New Zealand’s dairy and meat export prices can be attributed to the global trend. In addition, we find evidence that the divergence between commodity prices and our estimate of the global trend can be used to forecast individual commodity prices, in particular dairy prices. We conclude that if dairy prices are above the level implied by the global trend, then they will tend to fall until they reach the level implied by the global trend and vice versa.