In late 2020, the price of iron ore was driven primarily by growth in demand across all commodities and specifically for bulk goods, the Reserve Bank of Australia (RBA) said.

Instead, in early 2019, the rise in iron ore prices was largely attributed to specific developments in the iron ore market as a result of temporary supply disruptions.

According to the RBA, this comparison highlights that it is important to understand the nature of commodity price shocks when analyzing the role that commodity prices play in driving exchange rate movements.

The relative importance of supply and demand drivers for iron ore prices in early 2019 and late 2020 can be quantified using econometric models, such as the Cunningham Commodity Factor Pricing Model and Smith (2019).

This model breaks down price movements into changes that are specific to iron ore, common to all bulk commodities, or common to all commodities.

For example, the rise in the price of this product for much of 2019 was associated with temporary supply disruptions in Brazil and Australia.

Iron ore

As these price movements were expected to be short-lived, they did not lead to large increases in capacity or production by Australian producers.

Furthermore, the increase in mining profits derived from higher commodity prices did not significantly boost domestic household income.

As a result, it is not surprising to the RBA that the exchange rate did not move closely with commodity prices during this period.

However, since the end of 2020, commodity prices have been more closely associated with movements in the Australian dollar.

In fact, the appreciation of the Australian dollar since November 2020 has been broadly consistent with rising commodity prices.

These events have taken place in a context of improving expectations for a recovery in world growth.

During this period, the price of iron ore rose significantly due to increased Chinese demand for steel and is at its highest level in a decade.

In this environment, improving investor sentiment supported demand for a variety of «risk sensitive» assets, including equities, many commodities and the Australian dollar.