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Correlation structure between inflation and oil futures returns: An equilibrium approach

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  • Casassus, Jaime
  • Ceballos, Diego
  • Higuera, Freddy

Abstract

We use an equilibrium model of a monetary economy to understand the economics behind the correlation between inflation and oil futures returns. We find that some of the positive correlation found in empirical studies is due to the fact that oil is in the consumption basket; however, this accounts only for a minor part of it. There exist other important sources of correlation related to monetary shocks and output shocks. In particular, we find that the correlation is extremely sensitive to the reaction of the central bank to output shocks, while the reaction to inflation changes is less significant. We estimate our model using maximum likelihood with the following data sets: crude oil futures prices, nominal interest rates, inflation rates and money supply growth rates. Our estimates suggest that the monetary authority overreacts to output shocks by increasing the money supply in a more than necessary amount, generating a significant source of positive correlation. From a practical perspective, We find that it is a good strategy to use as a hedge, the futures whose maturity is closer to the hedging horizon. This is particularly true for short-term hedging.

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Bibliographic Info

Article provided by Elsevier in its journal Resources Policy.

Volume (Year): 35 (2010)
Issue (Month): 4 (December)
Pages: 301-310

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Handle: RePEc:eee:jrpoli:v:35:y:2010:i:4:p:301-310

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Web page: http://www.elsevier.com/locate/inca/30467

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Keywords: Correlation structure Inflation Futures Hedging Oil Monetary policy;

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References

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Cited by:
  1. Necibi, Thameur & Issaoui, Fakhri, 2013. "The impact of oil prices on economic activity in administrated price structure: the case of Tunisia," MPRA Paper 50420, University Library of Munich, Germany.

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