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Oil prices and expected inflation

Since the end of the Great Recession, market-based measures of long-run inflation expectations have seemed highly correlated with the spot price of oil. To see what we mean, consider the FRED graph above, where we plot the price of oil (West Texas Intermediate) against the 5-year, 5-year forward expected inflation rate. This measure of expected inflation is calculated using measured yield differentials between nominal and inflation-protected Treasury securities (TIPs) at 10- and 5-year maturities. (To further highlight the correlation, consider the scatter plot of the same data below.)

The 5-year, 5-year forward rate is meant to capture the bond market’s 5-year average forecast of inflation beginning 5 years from now. In this way, anything expected to affect the economy over the next 5 years should not factor prominently in a long-run forecast made 5 years from now. But then, why should the contemporaneous price of oil correlate so highly with the long-run inflation rate which is, or should be, anchored by monetary and fiscal policy?

One possibility is that because the stock of oil is an asset, its price is likely to include a forward-looking element. If the long-run outlook for global growth weakens, the value of this asset should decline. In the event of a long-run forecast of low growth, low interest rates, and low inflation, investors will move away from private sector securities into safe assets, such as U.S. Treasury securities. If so, the value of the stock of oil declines along with expected inflation.

How these graphs were created: Search for “5-year, 5-year Forward Expectation Rate.” From the “Edit Graph” panel, use the “Add Line” tab to search for and add the “Crude Oil Prices: West Texas Intermediate” series. With the “Format” tab, change the “Y-axis position” option to “Right” for “LINE 2.” For the second graph, use the “Format” tab to select plot type “Scatter.”

Suggested by David Andolfatto and Mahdi Ebsim.

View on FRED, series used in this post: DCOILWTICO, T5YIFR

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