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CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition by CAIA Association

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27.3 COMMODITIES AND THE BUSINESS CYCLE

The Federal Reserve Bank targets the core inflation rate, which excludes the very volatile energy and agriculture indices. When commodity prices increase to very high levels, however, the effects start to show in the core inflation, which induces a reaction from the central bank in order to keep inflation under control. This is why the interdependencies between monetary policy and commodity prices need to be discussed. The effect of a contractive monetary policy can be thought of as a continuation of the inflation effect and, perhaps, the start of a recessionary phase of the business cycle. As discussed previously, an increase in inflation raises commodity prices as investors take advantage of the inflation hedging property and increase their demand for commodities. Higher inflation then induces the central bank to increase interest rates in order to decrease inflation. The following period of disinflation reduces the demand for commodities, so their prices return to their long-run levels. Armesto and Gavin (2005) find evidence that commodity futures markets respond positively to an unexpected increase in the federal funds rate target by raising the inflation rate expected by the market participants for the next three to nine months. Jensen, Johnson, and Mercer (2002) analyze the effects of monetary policy in the United States by distinguishing between subperiods of expansive and contractive monetary policy.15 For the time period 1973 to ...

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