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Does the market believe the change in oil prices is permanent?

Oil prices fell dramatically in the last half of 2014, from a high of $107.49 on June 13, 2014, to $54.14 on December 30, 2014, and continued to fall into early 2015. During the same period, a measure of 5-year inflation expectations declined in a similar way. The graph shows the unusual correlation between these two series from January 2014 to the present. The red line is the daily 5-year breakeven inflation rate from the beginning of 2014 to the present. (That breakeven inflation rate is computed from the difference between the 5-year Treasury inflation-protected security, or TIPS, and the 5-year Treasury and is a measure of market expectations of future inflation.) The blue line is the daily price of West Texas Intermediate crude oil.

Market expectations of the inflation rate 5 years out held steady for the most part from early 2013 to early 2014. On April 17, 2014, inflation expectations jumped up. After June 2014, oil prices fell precipitously, taking inflation expectations down with them. After January 27, 2015, oil prices stabilized and began to rise. Again, market inflation expectations rose.

While oil prices can pass through and affect other prices, the almost one-to-one movements in the two series seem to be unusual. Pass-through from oil to other prices is incomplete. If the price increase in oil was deemed to be temporary, the 5-year inflation rate would not move in unison with oil prices (little pass-through). In this case, it appears there’s at least some belief that the change in oil prices will persist, as there is substantial pass-through.

How this graph was created: Search for “crude oil prices,” select the series “Crude Oil Prices: West Texas Intermediate (WTI) – Cushing, Oklahoma,” and graph it on a daily frequency. Select the “Add Data Series” option: Search for “5-year breakeven inflation,” select the first series shown (“5-Year Breakeven Inflation Rate, Daily, Percent, NSA”), and add it as a new series. Select the “Edit Data Series 2” tab and change the y-axis position from left to right. Finally, set the start date to 2014-01-01.

Suggested by Michael Owyang and Hannah Shell.

View on FRED, series used in this post: DCOILWTICO, T5YIE

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