DP11535 | Has Inflation Targeting Become Less Credible? Oil Prices, Global Aggregate Demand and Inflation Expectations during the Global Financial Crisis

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Following the onset of the global financial crisis (2008) we witness a strengthening of the correlation between crude oil prices and medium-term inflation expectations. Using the first principal component of commodity prices as a measure for global aggregate demand, we decompose oil prices into a global demand factor and idiosyncratic factors that include supply side effects and weather conditions. The decomposition of oil prices allows us to show that since the crisis, global five-year breakeven inflation rates react quite strongly to global aggregate demand conditions embedded in oil prices. The result suggests that market participants perceive inflation targeting as either less effective around the effective lower bound or less aggressive when inflation deviates below target. Alternatively, it may be that in recent years monetary authorities have additional considerations such as macro-prudential issues.