Impact of Oil Price on Inflation Expectations

January 27, 2011 | Greg Leonberger, FSA, EA, MAAA, FCA, Partner, Director of Research

In the last four months of 2010, the price of oil rose from $72 as of August 31st to $91 as of December 31st, an increase of 26%. Over that same time period, the breakeven rate (the difference in yield between the ten year TIP and ten year nominal treasury) increased 34%, from 1.68% to 2.25%. Because the breakeven rate is commonly used as a proxy for inflation expectation, it is not a stretch to think that the run up in oil prices was driving inflation expectations (and inevitably, stories of “rising inflation” always seem to appear shortly after the price of oil shoots up). This week’s Chart of the Week compares inflation expectations (measured by the breakeven rate) with oil prices, to see if there really is a strong correlation between the two values. The blue bars represent the price of oil at the end of each month, and the red line chronicles the breakeven rate at each month end; data is used going back to 2003. Between 2003 and 2007, there seems to be a loose connection between the two, but it is not very tight, as the price of oil slowly creeps up but the breakeven rate is relatively static. From late 2008 through the end of 2010, the graphs seem to mirror each other more closely, most especially in late 2010. In total, however, the correlation is only .18, thus we conclude that the price of oil does not have a strong impact on expected inflation values, in spite of what we hear and read when oil prices rise dramatically.