Is the Oil Price-Inflation Relationship Transitory?
The relationship between oil prices and inflation has been widely discussed for decades, but its exact identity remains largely ambiguous. What makes the problem particularly difficult is that oil and inflation are highly intertwined. Their connections are difficult to disentangle using conventional statistical methods as frequent regime changes make the direction of causality difficult to pinpoint, producing results that are extremely sensitive to the sample selection. The difficulties in reaching robust conclusions give rise to many explanations of the transmission channels between oil and inflation.
The academic work on the impact of oil shocks on inflation has always been the topic of prime importance for the policymakers. More recently, the attention shifted to the analysis of inflation expectations, and whether highly volatile and easily visible gasoline prices at the pump may have a disproportional impact on forming short-term consumer beliefs about future inflation. These consumer inflation expectations could then affect the actual inflation via the demand for higher wages, which makes oil prices an influential factor on monetary policy decisions.
This Comment outlines less visible transmission channels established by the behavior of market participants that play an important role in reinforcing the feedback loop between the oil price and inflation. It is argued that causality depends on the investment horizon resulting in simultaneous crosscurrents of financial flows between oil and inflation markets. In the short-term, highly volatile energy prices drive the realized measures of inflation, and the activity of cross-asset arbitrageurs ties short-term inflation expectations to energy futures curves. The short-term market-implied inflation expectations then propagate throughout the inflation forward curve with the help of interest rate carry traders. Surprisingly, the tight relationship persists even for a longer-term horizon where it can no longer be justified fundamentally. Long-term market-implied inflation expectations then return the favor and impact the financial demand for petroleum futures via portfolio allocations of large institutional investors, such as risk parity funds. The relationship becomes circular where the strength in one propels the other.