Why More Jobs Means Lower Commodity Prices
At first glance, it would seem logical to assume that as the U.S. employment rate increases, so too would the price of global commodities. This conclusion rests on the premise that working citizens have greater disposable income to spend on items such as food, energy or white goods. Furthermore, while the U.S. makes up less than 5 percent of world population, it consumes a much greater per capita percentage of raw materials. According to the Sierra Club’s Dave Tilford, America uses one-third of the world’s paper, a quarter of the oil, 23 percent of the coal, 27 percent of the aluminum and 19 percent of the copper. In other words, the U.S. has a significant influence on commodity demand -- and prices.
Yet there’s actually a positive correlation between the U.S. unemployment rate and global commodity prices: Historical data over the last 10 years reveals that the two largely move in tandem. While commodities, as tracked by the S&P Goldman Sachs Commodity Index, a basket of about 24 commodities, are more volatile than the unemployment rate, they nevertheless show a similar trend to unemployment.
Which index is leading versus lagging? Surely it takes a number of years to dig a mine or build a smelter and finally hire workers. A 2011 study revealed that surges in the average price of gasoline at the pump tend to lead to spikes in the U.S. unemployment rate within roughly two years. The study shifted the unemployment rate data earlier by 24 months to better show the apparent correlation. With an R2 coefficient of determination of 0.545, the study suggests that the price of gasoline can explain 54.5 percent of the variation in the U.S. unemployment rate two years later. Although it is far from perfect, the correlation did show that Americans can use their perceptions of the cost of gasoline as a measure of how they'll be doing economically two years from now. Today’s low cost at the pump leads to optimism for the future.
So why the positive correlation? For one, economic growth and technological advancements lead to efficiency. When the economy is growing, manufacturers and other commodity-consuming industries experience an efficiency feedback loop. As they become more resourceful, they require less raw material inputs throughout the supply chain enabling them to shore up capital to grow their labor force. Today it takes less steel and other heavy metals to produce cars and trucks and thus less energy to power those vehicles thanks to fuel efficiency. Meanwhile, the amount of renewable energy produced in the U.S. is growing as are the number of people the industry employs, pushing down the price of traditional fossil fuels.
Second, since the financial crisis, the U.S. has been able to achieve employment growth through easy monetary policy, which is what the Federal Reserve did until the fourth quarter of 2016. This policy lowered interest rates, which is good for businesses, as they can more easily raise debt, expand and thus hire more employees. Commodity producers can drill more wells, dig deeper mines, construct more smelters and refiners and grow more crops, all requiring more employees. And along with this expansion comes greater commodity supply, pressuring prices down, as we have seen with crude oil and grains.
Third, it’s imperative to take into account the falling labor participation rate in the U.S. as well as an aging population that consumes measurably less than younger age groups. And both of these trends are predicted to continue.
Looking ahead, this positive correlation is likely to persist, meaning low unemployment and lackluster commodity prices in the coming years. The Trump administration is emphasizing more U.S. production of fossil fuels and nuclear energy, along with growth in metals manufacturing and agriculture output, which should serve to keep unemployment low.
In addition, while U.S. interest rates are still historically low, as is inflation, expectations for further rate hikes work to reduce the real market price of commodities. They increase the incentive for extraction today rather than in the future. That is why when rates rise, more oil is drilled, more ores are extracted from the ground and more herds are culled. Higher rates disincentivize businesses to carry inventory such as copper tubing, lumber or oil in tanks. Higher rates encourage speculators to shift out of financial commodities into fixed-income instruments offering greater yield. Finally, higher rates, and expectations thereof, will cause the U.S. dollar to appreciate, thereby reducing the price of commodities, which are globally traded in U.S. dollars.
All of these mechanisms were in place when real interest rates were high in the early 1980s. A decrease in real interest rates has the opposite effect -- lowering the cost of carrying inventories, and raising commodity prices -- as was the case in 2007-08 and 2010-11.
Even while the unemployment rate is impressively low, both wages and salary growth are trending downward putting a damper on consumer spending. Adding to this picture, government non-health programs as a percent of U.S. gross domestic product are on a decline and wealth inequality is growing, only disproving the argument of greater commodity demand by the employed.
The bottom line is that commodities have tumbled 9 percent since mid-February. Major banks such as Goldman Sachs, among others, have acknowledged that some factors weren’t predictable. Perhaps in the future, they should focus on unemployment and other aspects of the U.S. labor market as good indications of where commodity prices are headed.
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Max Berley at email@example.com