…The claim that, in normal times, energy prices have a direct influence on long-term inflation expectations is puzzling, as it seems to imply that monetary policy is not able to offset price shocks even five or ten years down the road. If confirmed, it could have significant implications on how inflation dynamics are forecast. Hence, we believe that the claim warrants further scrutiny.
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In a recent paper, using daily data from the euro area, we presented estimates confirming that oil price changes have been positively and significantly correlated to market-based inflation expectations since the Global Crisis (Conflitti and Christadoro 2018). Even the five-year-ahead, five-year forward return on swaps (i.e. the difference between the ten-year and the five-year swaps), a key measure for monetary policy, showed a statistically significant correlation with oil prices. However, this is only true in a simple regression that does not take into account other relevant variables. A more thorough analysis leads to different conclusions.
To ascertain whether this is the case, we estimated a model where we controlled for macroeconomic developments (like changes in stock prices and economic surprises). In this case, over the full sample (2006-2017) the relationship between oil prices and inflation expectations waned. However, it remained significant for the 2014-16 period, when oil prices fell markedly, and the recovery looked weak and uncertain – especially in the euro area.
The 2014-16 period is also remarkable in that the correlation between short- and long-term inflation expectations rose from basically zero prior to the financial crisis to 0.4% in the period from June 2014 to January 2016, as oil prices fell from $110 per barrel to less than $30.3
A possible rationalisation of this increase is that the persistence of low inflation raised fears that the global economy (at least in advanced countries) was on the brink of a secular stagnation, and that monetary policy was unable or unwilling to restore price stability (Neri and Notarpietro 2015, Obstfeld et al. 2016).
In this situation, negative shocks to demand and prices are likely to affect expectations beyond the short term. Indeed, as pointed out in the literature, short- and long-term inflation expectations have become more synchronous, which is evidence of inflation expectations disanchoring, as argued by (among others) Natoli and Sigalotti (2016). The rise in the correlation between long-term inflation expectations and oil price changes is therefore an indirect effect of inflation expectations disanchoring.
Again, to find out whether this mechanism was indeed at work in 2014-16, we estimated a model that controlled for the impact of variations in short-term inflation expectations on expectations further away in time. The effect of oil price changes on long-term inflation expectations vanishes completely once we control for short-term inflation expectations. This finding confirms that oil price changes seem to affect longer-term inflation expectations only because, and to the extent that, their impact transits through short-term ones.
Including monetary policy surprises in the model, the effect of oil prices on long-term inflation expectations is further reduced over the 2014-16 period, thanks to their mitigating effect on the correlation between short- and long-term expectations. This also suggests that factors other than oil prices influenced the transmission of oil shocks to inflation expectations hence the claim that oil prices directly affect inflation expectations at horizons relevant for monetary policy credibility is much weakened by our results.
For quite some time, inflation has been very low in advanced economies. Since 2014, falling oil prices have contributed to this trend. However, the strong relationship between oil prices and long-term inflation expectations observed over the last few years is spurious. Our results show that:
- the impact of oil prices on long-term inflation expectations is much weakened, once the economic cycle (proxied by stock market and confidence indicators) is taken into account.
- the direct effect of oil prices on long-term inflation expectations is never significant once we control for their impact on short-term ones…
- the doubling of oil prices from the lows reached in 2016 has helped inflation recover somewhat in the euro area, but will not per se result in a sustained adjustment in price dynamics, nor will it lift long-term inflation expectations.
Our results suggest that, in order to achieve a sustained adjustment of both actual and expected inflation, a firming of the recovery is needed. In turn, this arguably requires that monetary policy be perceived as strongly and credibly committed to this aim.