By Alejandro Badel, Economist, and Joseph McGillicuddy, Research Associate
Oil prices have continued to decline over the past few months, dropping to nearly $30 per barrel by last December. This drop coincided with a fall in breakeven inflation expectations, as measured using the premium paid for Treasury inflation-protected securities (TIPS) over standard Treasury bonds.
If the fall in breakeven inflation rates reflects a fall in actual inflation expectations, and assuming this fall is largely driven by a fall in oil price expectations, then we can ask the following question: How low would future oil prices have to fall to validate current breakeven inflation rates?
To address this question, we started by calculating the future path of the consumer price index (CPI) implied by breakeven inflation expectations at December 2015 (the last observation in the figure above). Then we used a simple model to back out the future path of oil prices that is consistent with such a future path of the CPI.
The model predicts the future path of the CPI given an assumed path of future oil prices. We used it in our previous blog post to predict the impact of different future oil price scenarios on inflation rates. The model predicts the future path of the CPI as the weighted sum of two components—energy and all items less energy—under the following assumptions:
The figure below shows a backtest of our model from July 2014 to December 2015.1 As demonstrated by the figure, the model predicts the actual path of annual CPI inflation over this time period quite well.
According to our calculations, oil prices would need to fall to $0 per barrel by mid-2019 in order to validate current inflation expectations. After that, there is no oil price that would allow our model to predict a CPI path consistent with December 2015 breakeven inflation expectations. This implied path of oil prices is very different from the path of oil prices implied by futures contracts, which rises to more than $50 per barrel by mid-2019.
We state some potential explanations for our results:
1 In this backtest, we performed an out-of-sample prediction of the CPI from July 2014 to December 2015 using the actual path of oil prices over that time period. This is the future CPI path our model would have predicted in June 2014 assuming that we knew what oil prices would be through the end of 2015.
2 We used the December 2015 breakeven inflation expectations to estimate December values of the CPI over the next 10 years from December 2016 to December 2025. We obtained the remaining monthly CPI values by assuming constant growth of the CPI between each of these December estimates.
3 The value of the elasticity of energy component with respect to oil price was estimated via ordinary least squares. See the second figure of our previous blog post.
4 An oil futures contract is a standardized agreement, tradable between parties on an organized exchange, for the seller to deliver a certain quantity of oil to the buyer on a future date at a specific price determined today. The prices of such contracts are often interpreted as the market’s forecasts of spot oil prices.
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