Commodity Prices and Inflation Expectations in the United States

Resume from IMF Working Paper  Commodity Prices and Inflation Expectations in the United States
Summary

U.S. monetary policy can remain extraordinarily accommodative only if longer-term inflation expectations stay well-anchored, including in response to commodity price shocks. We find that oil price shocks have a statistically significant, but economically small impact on longer-term inflation compensation embedded in U.S. Treasury bonds. The estimated effect is larger for the post-crisis period, and robust to controlling for measures of liquidity risk premia. Oil price shocks are also correlated with the variance of longer-term inflation expectations in the University of Michigan Survey of Consumers in the post-crisis period. These results are not attributable to looser monetary policy - oil price increases were associated with expectations of a faster monetary tightening after the crisis. Overall, the findings are consistent with some impact of commodity prices on long-term inflation expectations and/or on inflation rate risk.

 Assuming (in line with empirical evidence) that oil price shocks take about four quarters to feed into domestic prices, a one percent increase in oil prices would directly add about five basis points to expected inflation in the year ahead, and one basis point for average inflation expected over the next five years.

Rising commodity prices pose challenges to macroeconomic management and could create new headwinds for the U.S. economic recovery. They can lower the growth of private consumption by reducing real disposable income, and hurt investment and job creation by diverting firms’ resources into covering the higher cost of energy inputs. Moreover, higher commodity prices can feed into core inflation—changes in the index excluding food and energy items—triggering expectations of a tighter monetary policy stance, and thereby adding to the adverse impact on aggregate demand.

We find that:

• Oil and food price changes have a statistically and economically significant impact on near-term (0–5 year) TIPS-based inflation compensation—as expected, given the direct pass through of commodity prices into headline inflation.

• Oil price changes also have statistically significant, but economically small effects on long-term (5–10 year) TIPS-based inflation compensation. These estimated effects are stronger for the post-crisis sample.

• Oil price fluctuations appear to have contributed to higher inflation uncertainty since the crisis. In months of large oil price fluctuations, consumers’ longer term inflation expectations are spread out more widely.

• Oil price changes had no systematic effect on the expected monetary policy stance before the 2008 crisis, consistent with the inflationary effects of higher oil prices being offset by lower aggregate demand and a wider output gap.

• Yet after the crisis, oil price increases have on average led to expectations of a faster monetary policy tightening. This suggests that, during the recovery, markets associated oil price increases with a faster U.S. recovery and a smaller output gap.

CONCLUSIONS

We examined the sensitivity of U.S. inflation compensation to commodity price shocks before and after the 2008–09 financial crisis, using market- and survey-based data. We find that oil and food price shocks have a significant impact on short-term inflation compensation embedded in U.S. Treasury bonds, consistent with the pass-through of commodity price shocks to headline inflation. More surprisingly, oil price shocks also have a statistically significant, albeit economically small, impact on longer-term inflation compensation. Both short- and long-term inflation compensation have become more responsive to oil price shocks since the crisis, possibly due to increased inflation uncertainty, especially in the shorter term.
 

The higher sensitivity of short-term inflation compensation to oil prices since the crisis is not attributable to expectations of a weaker monetary policy response relative to the pre-crisis period—our results in fact suggest that oil price shocks raised near-term expectations of federal fund rates more strongly in the post-crisis period. It thus appears more likely that on average markets associated oil price increases with a stronger U.S. economic recovery in the aftermath of the Great Recession, thereby raising their expectations of inflation and policy interest rates simultaneously.
 

The sensitivity of long-term inflation compensation to commodity price shocks is consistent with their impact either on inflation expectation or on perceived inflation rate risk.