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Oil, inflation, and financial markets

University of British Columbia

The economy’s heavy dependence on fossil energy links oil prices to real economic activities, inflation, and financial markets. This dissertation studies the extent to which fluctuations in oil prices are related to inflation and the prices and expected returns of Treasury bonds. Chapter 2 shows that the correlation between U.S. core inflation and oil price changes exhibits a time-varying pattern since the 1970s. The significant resurgence of the positive correlation after the 2007 financial crisis is puzzling, given the subdued macroeconomic impact of oil price shocks since the mid-1980s. A two-sector DSGE model illustrates that the relation between the price of oil and core inflation depends on the type of shocks embedded in oil price changes. Oil supply shocks cause the price of oil and core inflation to co-move, whereas the aggregate demand shocks driven by economic growth lead to opposing changes in the price of oil and core inflation. The economic mechanisms uncovered in the model and historical geopolitical events together provide a consistent and logical explanation of the time-varying correlations observed in the data. Chapter 3 examines the economic impact of oil prices on Treasury bond returns. I find novel evidence that growth rates of crude oil prices can explain contemporaneous excess returns on nominal U.S. Treasury bonds and inflation swaps, and also predict expected future excess returns on inflation swaps. Empirical results suggest that the impact of oil prices on nominal bonds is through the impact on expected inflation. I then build a two-sector New Keynesian model to study theoretical interactions between the economic drivers of oil prices, expected inflation, and bond yields. The model shows that oil supply and demand shocks have opposite impacts on bond yields and expected inflation. The conventional wisdom that high oil prices lead to high expected inflation and nominal yields is true only if high oil prices are driven by a negative shock to the supply of oil. In contrast, when oil prices are driven by a positive shock to productivity growth, high oil prices can lead to low expected inflation and nominal yields.

Text

2016-07-18

Attribution-ShareAlike 4.0 International

http://hdl.handle.net/2429/58469

Business Administration - Finance

University of British Columbia

UBCV

http://creativecommons.org/licenses/by-sa/4.0/