Blog Post

Oil prices and inflation expectations

The price of crude oil has fallen even further in recent weeks, as have financial market measures of inflation expectations in the euro area, the US and the UK. We show that low oil prices drag down inflation expectations up to 5-6 years ahead, which is puzzlingly long and suggests that financial market based inflation expectations should be assessed cautiously.

By: and Date: January 21, 2016 European Macroeconomics & Governance Tags & Topics

The link between oil prices and inflation expectations has been established by a number of studies. Alejandro Badel and Joseph McGillicuddy from the Federal reserve Bank of St Luis and Nathan Sussman and Osnat Zohar from the Bank of Israel use an econometric technique to disentangle aggregate demand shocks, oil supply shocks and other oil-specific shocks.

They found that market-based measures of inflation expectations have correlated quite well with oil-related shocks since the onset of the global financial crisis, while the correlation was weaker before.

There is indeed a correlation, as shown in Figure 1. This is especially the case when considering short-maturity (for example 1 year) inflation expectations. 10-year maturity inflation expectations also appear to correlate with the oil price, but to a lesser degree.

Figure 1: Oil price and financial market-based inflation expectations (inflation swaps), weekly data, July 2007 – January 2016

Source: Thomson Reuters Datastream. Note: Market based inflation expectations refer to zero-coupon swaps over a time horizon of 1 and 10 years. Weekly average data; for the most recent week the average of 18-20 January 2016 is used.

chart_1_weekly_all

Oil-related products account for about 10 percent of consumption, and so it is straightforward that they have an impact on short-term inflation expectations. They also have an indirect impact on core inflation (see article).

However the impact on longer term expectations is more puzzling. David Elliott et al from the Bank of England show that even the expected 5-year inflation 5 years from now (5y5y inflation expectation) is influenced by current oil price movements, at least in the euro area and the United States.

Elliott and his co-authors carry out a simple regression for the daily changes in inflation swap rates on constant, contemporaneous and lagged daily percentage changes in spot oil prices, and lagged inflation swap rates (see annex). They studied the impact of oil prices on 3-year and 5y5y expectations. We use their regression model for weekly data to look at:

  • the impact of oil prices on expected average inflation for up to 10 years, and
  • the duration during which current oil price changes impact expected annual inflation in later years.

A 10 percent increase in oil prices lifts 1-year inflation expectations by 25 basis points and lifts 10-year inflation expectations (expected average inflation in the next 10 years) by about 10 basis points in the United States, as shown in Figure 2.

That is, if oil prices permanently increased by 10 percent (e.g. from 30 dollars/barrel to 33 dollars/barrel), then 1-year inflation expectations would increase by 0.25 percentage points from 0.78 percent to 1.03 percent and the 10-year inflation expectation figure would increase by 0.10 percentage points from 1.62 per cent to 1.72 per cent.

The estimated impact is slightly smaller in the UK than in the US for shorter-term expectations, but practically the same for longer-term expectations. The impact is smaller in the euro area than in the US and UK for all durations, but is still sizeable.

The recent oil price fall is the major determinant of the fall in inflation expectations. For example, the 5-year inflation swap rate for the euro area fell from 1.05 percent in late November 2015 to 0.69 percent on 20 January 2016: according to our regression result, this fall was entirely the result of falling oil prices. With unchanged oil prices from late November, the 5-year inflation swap would have marginally increased from 1.05 in late November to 1.06 on 20 January 2016 according to our regression result.

Now we turn to our second analysis: finding out how long current oil price changes impact expected annual inflation in later years. We note that the 10-year inflation expectation figure can be seen as the average of annual inflation expectations in the next 10 years, that is, the average of the current 1-year inflation expectation (e.g. from January 2016 to January 2017), the annual inflation expected between 1 year and 2 years from now (e.g. from January 2017 to January 2018), the annual inflation expected between 2 years and 3 years from now (e.g. from January 2018 to January 2019), and so on, until the annual inflation expected between 9 years and 10 years from now (e.g. from January 2025 to January 2026).

Using different maturity inflation expectations, we calculate these expected future annual inflation rates. For example, using 1-year and 2-year inflation expectations we calculate expected annual inflation one year from now. After calculating these implied annual inflation rates in future years, we use the model to assess the impact of oil prices on these expected future annual inflation rates.

Figure 3 shows rather persistent effects: we find that current changes in oil prices significantly influence annual inflation expectations up to five years in the euro area and up to six years in the US and UK.

It is puzzling that the oil price has such a persistent effect on expected future inflation. Elliott and his co-authors discuss some factors that may explain this phenomenon beyond changes in inflation expectations, such as changes in the risk premia that investors demand when trading with inflation swaps, changes in investor behaviour and market structure.

Yet it is difficult to envision a mechanism which systematically moves in parallel with the changes in oil prices. For example, it is not very likely that risk premia concerning inflation 5-6 years ahead always fall when current oil price falls, while this risk premia increases when current oil price increases. It may be possible too that a low oil price now increases the likelihood that oil price and inflation will increase in the future, in which case a current low oil price may be associated with a higher risk premia about future inflation.

Another explanation for this puzzle may be that there is a common factor behind current oil price and expected future inflation changes, as Elliott and his co-authors argue. For example weak expected future demand may drive down oil prices now, and simultaneously expectations about future inflation.

In any case, we can draw two key conclusions.

First, since falling oil prices are strongly associated with falling inflation expectations, falling market-based inflation expectations (even at long maturities) cannot be taken as evidence against the effectiveness of the ECB’s quantitate easing.

This is because oil price changes are rather exogenous to ECB’s quantitate easing (we say “rather” and not “fully”, because if QE is able to revive the euro area economy, then it also increases European demand for oil, which may increase oil prices, yet we believe this channel is rather weak compared to the other factors influencing oil prices and even a more aggressive monetary policy would have not been able to prevent the recent falls in oil prices). Therefore, this conclusion is analogous to the conclusion we draw in a blog post last week analysing the impact of oil prices on core inflation.

Second, financial market-based inflation expectations should be assessed cautiously, because they are very sensitive to oil prices even for puzzlingly longer maturities, and can also be influenced by various other factors.

Annex: the regression

David Elliott, Chris Jackson, Marek Raczko and Matt Roberts-Sklar present a simple regression model for the daily changes in inflation swap rates on constant, contemporaneous and lagged daily percentage changes in spot oil prices, and lagged inflation swap rates.

We use the very same model, but we use weekly data for two reasons. First, euro-area data is rather noisy and the use of weekly average data reduces the noise. Second, for daily data we found that additional lags of changes in oil prices are also significant for all three economies and therefore amendments to the model would be justified. But for weekly data we found that the contemporaneous and one lag for the oil price change is sufficient.

Therefore, the regression model we estimate is the following:

ZD_PH_21_1_16_1,

where  ZD_PH_21_1_16_2 is a market-based measure of inflation expectations (annualised rate in percent),ZD_PH_21_1_16_3  is the difference operator, i.e. ZD_PH_21_1_16_4 , ZD_PH_21_1_16_5 is the weekly percent change in the price of oil measured in local currency, ZD_PH_21_1_16_6 is the error term and ZD_PH_21_1_16_7 are parameters to be estimated.

We also looked at whether expectations about future oil prices influence inflation expectations, by using forward rates for Brent oil price (and in the case of the euro area and UK, forward rates for exchange rate against the US dollar to calculate the Brent forward rate in domestic currency). However, the expected change in oil price never worked in our regressions: the estimated parameters were either statistically non-significant, or they were negative, counter-intuitively implying that an expected increase in oil prices leads to a decline in expected inflation.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic

Blog Post

unnamed
Simone Tagliapietra

OPEC's revival or swan song? First evidences from financial markets

On Wednesday, 30 November 2016, OPEC reached a milestone agreement to cut oil production by 1.2 million barrels a day in a long-awaited attempt to end the savage two-year downturn in prices that has shredded the budgets of its members. The deal will come into effect in January 2017 and it will mark a U-turn from the pump-at-will policy adopted by the group in November 2014.

By: Enrico Nano and Simone Tagliapietra Topic: Energy & Climate Date: December 2, 2016
Read article Download PDF More by this author

Policy Contribution

pc15_16European Parliament

Low long-term rates: bond bubble or symptom of secular stagnation?

Yields on European sovereign bonds have reached historically low levels in 2016. This secular decline in long-term sovereign yields is not limited to the euro area. Why are interest rates currently so low? Are low long-term trates justified by fundamental factors or is it an artificial phenomenon?

By: Grégory Claeys Topic: European Macroeconomics & Governance, European Parliament, Parliamentary Testimonies Date: September 26, 2016
Read article More on this topic More by this author

Blog Post

Marek Dabrowski

Iran: from isolation to economic cooperation

With some sanctions temporarily lifted, now is the chance for Iran to reintegrate into the global economy and political system. But comprehensive economic and political reforms are needed.

By: Marek Dabrowski Topic: European Macroeconomics & Governance Date: July 15, 2016
Read article More on this topic

Opinion

fratzscher-03
Reint_Gropp_m
p2-Kotz
jan-pieter-krahnen
odendahl-june14-1409577172
Beatrice Weder di Mauro
Guntram B. Wolff

Mere criticism of the ECB is no solution

What would happen if the ECB failed to respond to the excessively low inflation and the weak economy? And what economic policy would be suitable under the current circumstances, if not monetary policy?

By: Marcel Fratzscher, Reint Gropp, Hans-Helmut Kotz, Jan Krahnen, Christian Odendahl, Beatrice Weder di Mauro and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: April 10, 2016
Read article More on this topic

Blog Post

IMG_20150922_160434
Georg Zachmann

Is the oil price-GDP link broken?

Oil prices fell to a 12-year low at the beginning of 2016. We find that the drop in the past two years was primarily driven by expectations. In fact, changes in oil prices since 2008 are increasingly explained by expectations. In the past, expectation-driven oil prices drops were good news for the EU economy. However, the declining importance of actual changes in demand and supply for oil prices raises doubts about whether we can still expect a positive impact on EU GDP.

By: Domenico Favoino and Georg Zachmann Topic: Energy & Climate Date: March 31, 2016
Read article More on this topic

Opinion

Agnès Bénassy-Quéré
Guntram B. Wolff

ECB decisions put lack of fiscal union in the spotlight

Fiscal policy in the euro area is hardly supporting the recovery and the ECB. The EU needs a a proper fiscal union in order to stabilise the economy and inflation. We see four main avenues for achieving a viable fiscal framework.

By: Agnès Bénassy-Quéré and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: March 30, 2016
Read article More on this topic

Blog Post

Francesco Papadia
Guntram B. Wolff

Central banks: from omnipotence to impotence?

Like the price of financial assets, the market assessment of the capacity of central banks to achieve their price stability objective fluctuates between omnipotence and impotence. We do not agree with this binary view of the world and we examine in this post the case of the European Central Bank (ECB). We argue that the ECB still has some instruments left. It should consider moving beyond increasing sovereign debt purchases, which would be ineffective and pose risks. More important is to step up work on structural and fiscal policies.

By: Francesco Papadia and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: March 2, 2016
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

The impotency of central banks

What’s at stake: The negative market reaction to the latest efforts to provide further monetary stimulus has generated an important discussion on whether central banks have lost credibility in their abilities to fight downside risks and shore up economies.

By: Jérémie Cohen-Setton Topic: Global Economics & Governance Date: February 22, 2016
Read article More on this topic More by this author

Blog Post

Simone Tagliapietra

Iran faces a bumpy road back to global energy markets

Iran’s energy sector is vital for the country’s economy. Now that sanctions have been lifted, the government must reform the oil sector to encourage investment from international oil companies.

By: Simone Tagliapietra Topic: Energy & Climate Date: February 9, 2016
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

Oil and stock prices

What’s at stake: The recent positive link between oil and stock prices has been puzzling for most observers. While a decrease in the price of oil was traditionally seen as a net positive for oil importing countries such as the United States, the concurrent declines in the price of oil and the US stock market suggest that the relationship may be different in the current environment.

By: Jérémie Cohen-Setton Topic: European Macroeconomics & Governance Date: January 25, 2016
Read article More on this topic

Blog Post

kang
ligthart
Ashoka Mody

The ECB and the Fed: a comparative narrative

Although the Great Recession was viewed as a US problem, the Eurozone was affected by it from the start. This column compares the monetary policy responses to the Crisis by the Fed and the ECB. It argues that the US approach has been much more aggressive and proactive. The ECB failed to provide stimulus when needed, and as a result the Eurozone might slip into a low-inflation trap.

By: Dae Woong Kang, Nick Ligthart and Ashoka Mody Topic: European Macroeconomics & Governance Date: January 21, 2016
Read about event More on this topic

Past Event

Past Event

Central banking after the great recession

Have Central Banks lost their ability to control domestic inflation? Are macroprudential tools sufficient to ensure financial stability? Do new monetary tools, a closer relationship with fiscal policy and the renewed financial stability mandate require a new central banking paradigm?

Speakers: Ignazio Angeloni, Markus K. Brunnermeier, Claudia M. Buch, Grégory Claeys, Charles Goodhart, Dirk Schoenmaker, Andrzej Rzońca, Cecilia Skingsley and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: January 18, 2016
Load more posts