Monetary Policy, Commodity Prices, and Misdiagnosis Risk

How should monetary policy respond to commodity prices when the underlying drivers are difficult to diagnose accurately? If monetary authorities misdiagnose commodity price swings as being driven primarily by external supply shocks when they are in fact driven by global demand shocks, the conventional wisdom-to look through the first-round effects of commodity price fluctuations-may no longer be sound policy advice. To analyze this question, we employ the multi-economy DSGE model of Nakov and Pescatori (2010), which splits the global economy into commodity-exporting and non-commodity-exporting economies. In an otherwise conventional DSGE setup, commodity prices are modeled as changing endogenously with global supply and demand developments, including global monetary policy conditions. This framework allows us to explore the implications of monetary policy decisions when there is a risk of misdiagnosing the drivers of commodity prices. We first confirm that monetary authorities deliver better economic performance when they are able to accurately identify the global nature of the shocks, i.e., global supply and demand shocks, driving commodity prices. Moreover, we show that when it is difficult to identify these shocks, monetary authorities can minimize some of the adverse feedbacks from misdiagnoses by targeting core inflation. Finally, we highlight the implications of misdiagnosis risk in the case where the monetary authority misinterprets supply-driven increases in commodity prices as demand driven; the contraction in both output and core inflation is larger than in the case of an accurate diagnosis. In light of recent empirical studies documenting the significance of global demand in driving commodity prices, these findings call for giving greater prominence to global factors in domestic monetary policymaking and highlight potential gains from focusing on accurate diagnoses of domestic and global sources of shocks.