David Elliott, Chris Jackson, Marek Raczko and Matt Roberts-Sklar.
Oil prices have fallen by more than 50% since mid-2014. For much of this period, financial market measures of both short-term and longer-term inflation expectations appear to have mirrored moves in oil prices, particularly in the US and euro area. But how strong is the relationship between oil prices and financial market inflation expectations, and what should we make of it?
The fall in oil prices and inflation swap rates
Oil prices fell sharply over the second half of 2014 (Chart 1), largely reflecting expectations of higher future oil supply. And they have fallen again in recent months, mainly reflecting slowing global demand.
Chart 1: Cumulative changes in 5y5y inflation swap rates and the Brent $ oil price since June 2014
Sources: Bloomberg, Bank and authors’ calculations.
At the same time, we’ve seen large moves in financial market measures of inflation expectations, even at longer maturities. For example, having been relatively stable since early 2013, 5-year inflation swap rates, 5 years ahead (often called 5y5y) fell by over 60 basis points in the second half of 2014 in the US. And the profile of moves seemed to mirror the fall in oil prices. Whilst there were similar moves in euro area inflation swaps, UK inflation swap rates fell later, by less, and have since recovered. So how should we interpret these moves?
An empirical relationship between oil prices and inflation swap rates does exist
To test the link between oil and financial market inflation expectations, we regressed daily changes in 3-year spot and 5y5y inflation swap rates on a constant, contemporaneous and lagged daily percentage changes in spot oil prices, and lagged inflation swap rates from January 2009 to July 2015. Our results are summarised in Chart 2.
We find that changes in oil prices have a statistically significant effect on UK, US and euro area 3-year inflation swap rates (which reference inflation over the next 3 years), with the effect largest for US swaps. The effect of oil prices on 5y5y inflation swaps (which reference inflation 5-10 years ahead) is lower in all three markets: the effect is statistically insignificant for UK swaps, but statistically significant for euro area and especially US swaps. The regression results imply that (for example) a 10% fall in the oil price is associated with falls of approximately 4 basis points in US 5y5y and 2 basis points in euro area 5y5y.
Chart 2: Sensitivity of inflation swap rates to oil prices, 2009-15(a)
(a) Sensitivities represent the cumulative impact of a one-percent daily increase in spot oil prices (Brent oil prices in local currency) on inflation swap rates. Sample period is from January 2009 to July 2015.
Sources: Bloomberg, Bank and authors’ calculations.
Should oil price changes affect inflation expectations 5-10 years ahead?
The textbook answer is no. Changes in oil and energy prices are clearly an important determinant of inflation in the near term – and so it makes sense for them to affect short-term inflation expectations, consistent with the significant effect in the regressions of changes in oil prices on 3-year spot inflation swaps. The fact that the relationship between oil prices and short-term inflation swap rates is stronger in the US and euro area than in the UK largely reflects the different weights on energy in inflation indices and differences in taxation (tax makes up a larger share of petrol pump prices in the UK, diluting the effect of changes in oil prices on petrol prices, compared to the US and euro area).
But you wouldn’t expect changes in the oil price to affect longer-term inflation expectations such as those reflected in 5y5y. A change in the oil price affects the price level, but the direct effect on year-on-year inflation drops out after one year. Longer-term inflation expectations should instead be pinned down by central bank inflation targets.
So what’s going on? Why do changes in oil prices have significant effects on longer-term US and euro area swap rates? One explanation is that inflation swap rates don’t give a clean read on market inflation expectations. As well as inflation expectations, they reflect the compensation that risk-averse investors demand because of uncertainty about future inflation and potentially illiquidity of these instruments – or ‘risk premia’. So moves in longer-term inflation swap rates might not always reflect changes in inflation expectations: they might instead be related to changes in these risk premia, e.g. because of changing perceptions about the balance of inflation risks, or changes in investor risk aversion. It’s also worth noting that longer-term inflation swap rates are generally more sensitive to moves in shorter-term inflation swap rates in the US than in the UK and euro area.
An alternative interpretation is that the relationship between oil prices and 5y5y inflation swap rates is being driven by common macroeconomic factors. For instance, falls in the oil price and inflation expectations might both be driven by expectations of weak aggregate demand in the future. Ordinarily, such demand shocks should not affect long-term inflation expectations as central banks can, in principle, use standard monetary policy tools to offset the effect of these shocks on inflation. But if market participants doubt that central banks will be able to successfully do this – perhaps because they expect central banks to be constrained by the zero lower bound, or because they believe household inflation expectations will fall – then expectations of reduced aggregate demand might indeed lead to falls in longer-term inflation expectations.
Why are UK inflation swaps less sensitive to oil prices?
The UK inflation market is structurally different to the US. On this side of the Atlantic, there is a large structural demand for inflation hedging as part of liability driven investment (LDI) by institutional investors, particularly defined benefit pension funds which have liabilities linked to inflation. The demand from these investors tends to push up implied measures of inflation expectations, particularly at longer maturities. And changes in their activity can have an important bearing on changes in forward inflation rates.
Market contacts consistently emphasise the importance of LDI activity in the UK inflation markets. Changes in UK 5y5y inflation may therefore reflect changes in the hedging strategies of these investors, rather than changes in inflation expectations. Market intelligence suggests LDI-driven demand for inflation protection probably increased further over 2014, as UK pension funds sought to meet end of year de-risking targets – and this helped support longer-term inflation swap rates in the UK as they fell in the US and euro area. This unusually strong demand for index-linked bonds for liability-hedging was also raised by contacts at the DMO’s annual consultation meeting with gilt market makers and end-investors in January. Market contacts report that subsequent fluctuations in this LDI-driven hedging activity may also help to explain the ebbs and flows in UK 5y5y inflation swap rates during 2015.
Do moves in oil prices drive longer-term financial market inflation expectations? The data imply an empirical link exists for the US and euro area, but not for the UK. But this is unlikely to reflect a direct impact of oil on actual expectations of future inflation at those long horizons. Instead, such changes in inflation swap rates could reflect a range of factors other than inflation expectations, including changes in investor behaviour, market structure and risk premia. All of which adds a note of caution when trying to gauge inflation expectations from market-based instruments.
David Elliott works in the Bank’s Sterling Markets Division, Chris Jackson works in the Bank’s Monetary Assessment and Strategy Division and Marek Raczko & Matt Roberts-Sklar work in the Bank’s Macro Financial Analysis Division.
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