The note delves on the U.S. housing market outlook, the potential benefits of mitigating distressed sales household deleveraging, and the recovery. Policies to facilitate labor market adjustment to reduce the large employment volatility without affecting efficient labor allocation could prevent problems. U.S. firms are hoarding money but it is likely to be spent to boost firms’ capital expenditure, rather than kept as precautionary balances. The note discusses commodity price shocks affecting Treasury inflation protected securities (TIPS), budget institutions for federal fiscal consolidation, and mortgage delinquencies in the United States.

Abstract

The note delves on the U.S. housing market outlook, the potential benefits of mitigating distressed sales household deleveraging, and the recovery. Policies to facilitate labor market adjustment to reduce the large employment volatility without affecting efficient labor allocation could prevent problems. U.S. firms are hoarding money but it is likely to be spent to boost firms’ capital expenditure, rather than kept as precautionary balances. The note discusses commodity price shocks affecting Treasury inflation protected securities (TIPS), budget institutions for federal fiscal consolidation, and mortgage delinquencies in the United States.

VI. How do Commodity Price Shocks Affect TIPS-Based Inflation Compensation?1

This chapter examines the sensitivity of TIPS-based inflation compensation to commodity prices. The findings suggest that the Fed needs to remain vigilant in the face of potential further commodity price shocks that could add to inflation uncertainty, even if past correlations suggest that the risk of longer-term inflation expectations becoming unmoored due to commodity price shocks of the magnitudes observed in recent months appears modest.

A. introduction

1. The recent months have seen significant increases in commodity and consumer prices as well as volatility in inflation expectations. The prices of crude oil and several food commodities rose sharply, and headline consumer price inflation increased from 1.2 to 2.2 percent SAAR between 2010Q4 and 2011Q1. Inflation expectations for the next one to five years have also gone up, consistent with estimates that commodity price shocks take up to 4–5 quarters to feed into domestic prices. Moreover, in March 2011 there was a noticeable jump from 2.9 percent to 3.2 percent in the closely watched longer-term expected inflation measure in the University of Michigan survey, which has been reversed since then.2

A06ufig01

TIPS-Based Imitation Compensation and Oil Pries

Citation: IMF Staff Country Reports 2011, 202; 10.5089/9781462317356.002.A006

Sources: Bloomberg LP, Harer Analysis and Fund staff calculations.

2. A temporary rise in commodity prices should not have a persistent effect on core inflation if longer-term inflation expectations and wage inflation remain stable. Accordingly, the Fed continues to signal that, given elevated resource slack, U.S. monetary policy is poised to remain accommodative for an extended period, as long as the outlook for inflation over the medium-term remains subdued.

3. A natural question at this juncture is whether potential further commodity price shocks could affect longer-term inflation expectations—which reflect the public’s perceptions of the Fed’s underlying inflation target and its ability to achieve that target. To help answer this question, we examine the sensitivity of inflation compensation embedded in Treasury securities—given by the difference between nominal (coupon) and inflation-protected Treasury yields—to commodity price shocks. Inflation compensation is not a perfect measure of expected inflation, since it also captures time varying liquidity and inflation risk premia. For subsamples where we can adjust inflation compensation for liquidity and inflation risk premia (the pre-crisis part of the sample), we find that adjusted and unadjusted inflation compensation respond very similarly to commodity price shocks. This finding suggests that the estimated response of inflation compensation to shocks mainly reflects the response of inflation expectations.1

B. Results

4. We regress daily changes in near-term (zero to five years ahead) and longer-term (five to ten years ahead) inflation compensation on oil and food price shocks, and the surprise component of macroeconomic data releases. Controlling for macroeconomic shocks is necessary to isolate the impact of commodity prices; for instance pressures on longer-term expectations from commodity prices in the recent months may have been offset by expectations of weaker medium-term aggregate demand (given intensified talks of a process of medium-term fiscal consolidation and lower observed near-term growth momentum). We also control for VIX as a measure of overall economic uncertainty.

5. As expected, oil and food price changes have a significant impact on near-term (0–5 year) inflation compensation (Table 1). Using daily data, we find that a ten percent increase in spot oil prices increases near-term inflation compensation by 0.09 percentage point. Similarly, a ten percent increase in food prices increases near-term inflation compensation by 0.04 percentage point. From August 2010 to April 2011, 0–5 year inflation compensation increased by 1.40 percentage point, of which 0.42 percentage point can be attributed to a 60 percent increase in spot oil prices, and 0.10 percentage point to a 30 percent increase in spot food commodity prices. We also find that the daily change in the oil price inflation rate expected for the year ahead has a statistically significant impact on 0–5 year inflation compensation.

Table 1.

The Sensitivity of TIPS-based Inflation Compensation to Oil and Food Commodity Price Shocks

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Note: p-values in parentheses; *, **, and *** denote significance at the 5, 1, and 0.1 percent levels, respectively. The explanatory variable is the daily difference in inflation compensation in percentage points. Oil and food commodity price shocks are expressed in percentages. S and S’ denote the spot oil price on consecutive trading days, F and F’ denote the price of the crude oil future contract a year ahead on two consecutive trading days, and FI and FI’ denote the spot food commodity price index on consecutive trading days. All regressions control for surprise components of key macroeconomic news releases: capacity utilization, CPI excluding food and energy, changes in nonfarm payrolls, current account, FOMC interest rate decisions, home sales, initial jobless claims, the ISM non-manufacturing survey, monthly budget, personal consumption, retail sales ex autos, and the unemployment rate, as in Gurkaynak et. al., 2005, “The Sensitivity of Long-Term Interest Rates to Economic News: Evidence and Implications for Macroeconomic Models”, American Economic Review 95(1): pp. 425–36. We also control for the daily percent changes in VIX.

6. Importantly for the design of monetary policy, shocks to oil prices also impact longer-term inflation compensation, although the estimated effect is considerably smaller than the effect on near-term compensation. A ten percent increase in spot oil prices increases 5–10 year inflation compensation by 0.02 percentage point. From August 2010 to April 2011, 5–10 year inflation compensation increased by 0.94 percentage point, of which only 0.09 percentage point can be attributed to the 60 percent increase in spot oil prices. Somewhat surprisingly, we don’t find any statistically significant effect of the change in expected one-year ahead oil price inflation on 5–10 year inflation compensation. Similarly, we do not find a significant effect of food commodity price shocks on longer-term inflation compensation.

C. Conclusion

7. There are three possible channels for the estimated effect of spot oil price shocks on longer-term inflation compensation. One is that markets perceive a higher chance of a sustained price rally when they observe a spot oil shock. This is not supported by the finding that changes in the expected oil price inflation for the year ahead have no impact on longer-term expectations. The second channel is that expectations of medium-term core inflation go up. The third is that commodity price volatility makes the monetary policy environment more complex, and hence increases perceptions of inflation rate uncertainty. This requires a higher inflation risk premium in nominal bonds, which increases our measure of inflation compensation. Our results suggest that both of the last two channels could be at work.

8. Even if past correlations suggest that the risk of longer-term inflation expectations becoming unmoored due to commodity price shocks is modest, the stability of longer-term expectations cannot be taken for granted. The findings of the regression analysis suggest that commodity price shocks have not shifted inflation expectations to a degree that would threaten medium-run inflation dynamics. However, the Fed needs to remain vigilant if the risk of potential further commodity price shocks increases, since these may have larger effects than in the past if inflation uncertainty increases or headline inflation remains higher than desired for a prolonged period.

1

Prepared by Oya Celasun, Roxana Mihet (RES), and Lev Ratnovski (RES).

2

The University of Michigan survey asks consumers about their expectation of average inflation over the next five to ten years, that is, over a horizon that includes the near term. Expected inflation in the longer term—for instance over the five year period that starts five years from now—can be derived from the Treasury inflation protected securities (TIPS) yield curve.

1

Inflation compensation is defined as coupon minus TIPS yields. It captures inflation expectations and time-varying liquidity and inflation risk premia associated with holding TIPS. We verify that the estimation results are robust to controlling for the time-varying liquidity risk. Liquidity risk is corrected by taking residuals from regressing inflation compensation on two of its proxies: (1) the spread between Treasury bonds and Treasury-backed but less liquid Resolution Funding Corporation bonds, and (2) the volume of TIPS transactions as a share of coupon transactions by primary dealers. We are able to control for liquidity risk only during 2003–08, as measures of liquidity during the crisis were contaminated flight to quality and the Fed’s large-scale asset purchases. Changes in inflation rate risk can be inferred from survey-based data using Kalman filtering, but the approach is not useful for high-frequency data. See the discussion in Gurkaynak et. al., 2010, “The TIPS Yield Curve and Inflation Compensation.” American Economic Journal: Macroeconomics 2(1): 70–92.

United States: Selected Issues
Author: International Monetary Fund