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

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 ag- gregate demand conditions embedded in oil prices. One explanation for this finding is that in recent years monetary authorities put greater emphasis on macro-prudential issues. Alternatively, it may be that market participants perceive inflation targeting as either less aggressive when inflation deviates below target or less effective around the effective lower bound.