Inflation and Commodities Correlation

Imagine you’re setting aside money for your child’s education, but suddenly, everything around you—groceries, fuel, school fees—starts getting more expensive. Inflation is eating into your savings, and your money doesn’t stretch as far as it used to. To safeguard your plans, you turn to gold—a time-tested hedge that often shines when prices rise.

This scenario captures the classic relationship between inflation and commodities. As inflation erodes the value of currency, tangible assets like gold and oil often gain value, making them attractive options for those looking to preserve purchasing power.

What Is the Relationship Between Inflation and Commodities?

Commodities have historically been viewed as a hedge against inflation. As inflation rises, the value of money falls, but tangible assets like gold, silver, and oil typically retain or increase in value. This inverse relationship is due to the fact that commodities are priced in fiat currency, and as the purchasing power of currency diminishes with inflation, the prices of these commodities tend to rise.

Why Do Commodities Perform Well During Inflation?

1. Rising Demand for Physical Assets:
During inflationary periods, investors seek to protect their wealth by shifting assets into commodities. This demand push leads to higher prices for commodities like gold, silver, oil, and agricultural products.

Example:
In India, gold is seen as a safe-haven asset, and during periods of high inflation, such as the 2008 global financial crisis or COVID-19 pandemic, demand for gold surged, pushing up prices as investors looked to safeguard their purchasing power.

2. Supply and Demand Imbalances:
Commodities like oil and agricultural products are directly impacted by inflation because the cost of production increases due to rising wages, transportation costs, and energy costs. This supply-side shock leads to higher prices for these commodities, further driving inflation.

Example:
The rise in crude oil prices due to geopolitical tensions or OPEC production cuts directly impacts inflation, especially in energy-dependent economies like India, where fuel price hikes increase transportation and manufacturing costs.

3. Cost of Carry:
During inflationary periods, the cost of carry (the cost of holding a commodity) increases. For physical commodities, this includes storage costs and interest rates. Higher inflation often leads to higher interest rates, which increases the cost of holding commodities and pushes their prices higher.

Inflation and Different Types of Commodities:

1. Precious Metals (Gold and Silver):
Precious metals, particularly gold, are considered traditional hedges against inflation. Historically, during periods of high inflation or economic uncertainty, gold prices tend to rise as it is viewed as a stable store of value.

Example:
During periods of rising inflation in India, especially in the 1970s and 1980s, gold prices surged as people moved away from cash holdings to preserve their wealth.

2. Energy Commodities (Oil, Natural Gas):
Energy prices are often directly influenced by inflation. When inflation causes higher production costs or increases demand for energy, the prices of oil, natural gas, and coal tend to rise.

Example:
In India, during periods of global oil price spikes (e.g., during the 2008 oil price crisis or Ukraine conflict in 2022), inflation surged as transportation and manufacturing costs increased across sectors.

3. Agricultural Commodities (Wheat, Rice, Sugar):
Agricultural products are significantly impacted by inflation, particularly when cost inputs like fertilizers, pesticides, and transportation increase. The prices of wheat, rice, and soybeans are heavily influenced by the monsoon season and inflationary pressures.

Example:
In India, the 2009-10 wheat price surge was partly driven by inflationary pressures on agricultural inputs. Similarly, during global inflationary periods, sugar and rice prices see marked increases in India, driven by both domestic supply and inflationary pressures.

Hedging Inflation with Commodities in India:

1. Gold as a Hedge:
In India, gold has long been considered a traditional hedge against inflation. During periods of high inflation, Indian households often increase their gold holdings, either in physical form or through financial products like gold ETFs or Sovereign Gold Bonds (SGBs). This trend has continued to persist, making gold a key component of inflation protection in the Indian economy.

2. Oil Hedging:
India, being a major importer of oil, is highly susceptible to inflation driven by rising oil prices. To hedge against potential oil price increases, businesses often use oil futures and options to lock in fuel costs and manage their operating expenses.

3. Commodity Mutual Funds and ETFs:
For Indian retail investors, commodity-focused mutual funds and ETFs offer easy access to commodity markets. These funds invest in a mix of agricultural, energy, and precious metals commodities, offering a diversified hedge against inflation.

The relationship between inflation and commodities is crucial for understanding how inflationary pressures can impact commodity prices and, in turn, influence investment decisions. Commodities like gold, oil, and agricultural products not only act as a hedge against inflation but also offer opportunities for investors to profit from rising prices during periods of economic instability. In the next chapter, we will explore Hedging with Commodities Derivatives, focusing on more complex financial instruments used for hedging and managing risks in the commodities market.