Strange Relations: The Correlation between Oil and Equities at the Zero Lower Bound

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When the Federal Reserve pushed its policy rate to zero in late 2008, a curious thing happened to oil prices and equity returns: Changes in the two, which had been uncorrelated, suddenly became highly correlated. Was this change triggered by a zero interest-rate policy?

Economist Paulina Restrepo-Echavarria and Research Associate Brian Reinbold looked at the connection between oil prices, equity returns and monetary policy in a recent issue of the Regional Economist.

Other economists have noted that the change in correlation started when the Fed reached the “zero lower bound.” The ZLB occurs when a central bank has lowered its policy rate—the federal funds target rate, in the case of the Fed—to near zero.

Before reaching the ZLB in 2008, the average rolling correlationA correlation coefficient of 1.0 means the two variables are perfectly positively correlated, a correlation of –1.0 means the two variables are perfectly negatively correlated, and a correlation coefficient of 0.0 means no correlation. A one-year rolling correlation calculates the correlation between two time series using the last year of data. between the change in the price of West Texas Intermediate crude oil and the change in the return on the S&P 500 index was only –0.04, suggesting no correlation, according to calculations by Restrepo-Echavarria and Reinbold.

With the Fed’s policy rate at zero between December 2008 and December 2015, the correlation averaged 0.40 during that time, they found.

“Also, we see that as the fed funds rate increased from zero starting in late 2015, the correlation between oil and equities eventually declined, although it is still too soon to make any predictions that price changes in oil and equity will become uncorrelated again,” the authors wrote.

Economists Deepa Datta, Benjamin K. Johannsen, Hannah Kwon and Robert J. Vigfusson offered their own hypothesis as to why this correlation changed.Datta, Deepa; Johannsen, Benjamin K.; Kwon, Hannah; and Vigfusson, Robert J. “Oil, Equities, and the Zero Lower Bound.” BIS Working Papers No. 617, Bank for International Settlements, March 2017. In a 2017 paper, the four economists posited that the central bank does not respond to inflationary pressure by changing interest rates when it’s at the ZLB.

As a result, changes in inflation can affect the real rate of interest differently at the ZLB. Thus, the impact on output, consumption, oil prices and equity prices is different at the ZLB.

If this hypothesis is true, then there should be a similar pattern found in other countries when their own policy rates reach the zero lower bound, according to Restrepo-Echavarria and Reinbold. So they looked at whether this also occurred in four other countries:

• The U.K.
• France
• Sweden
• Japan

The authors calculated correlations between the changes in the price of oil and changes in returns of stock indexes in those respective countries.

In the case of the European countries, the authors found that the correlation between the growth rate of oil and equity prices oscillated around zero up to 2008 and then become positive up to around 2012, just as in the U.S.

However, these European countries weren’t at the ZLB when the correlation increased; for those that did reach ZLB, they reached it around 2012, the authors observed.

Japan entered the ZLB in the early 2000s. Restrepo-Echavarria and Reinbold noted that “interestingly, we do not see a global spike in oil-equity correlations coinciding with Japan entering the ZLB.”

The cross-country evidence suggests that the inability of the monetary authorities to react to deflationary shocks doesn’t explain the change in the correlation between oil and equity prices.

“If this were the right argument, we would observe a coincidence between the correlation becoming positive and the policy rate becoming zero for all these countries, which is not the case,” Restrepo-Echavarria and Reinbold wrote.

Rather, the increased correlation in these countries coincided with the correlation in the U.S.

“This is because the stock exchanges in these countries are highly correlated with the S&P 500 and the price of oil is the same,” the authors concluded. “This means that this is a more general phenomenon that seems to be related more to the policy rate of the U.S. than to the policy rate of each individual country.”

¹ A correlation coefficient of 1.0 means the two variables are perfectly positively correlated, a correlation of –1.0 means the two variables are perfectly negatively correlated, and a correlation coefficient of 0.0 means no correlation. A one-year rolling correlation calculates the correlation between two time series using the last year of data.

² Datta, Deepa; Johannsen, Benjamin K.; Kwon, Hannah; and Vigfusson, Robert J. “Oil, Equities, and the Zero Lower Bound.” BIS Working Papers No. 617, Bank for International Settlements, March 2017.

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