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The Effect of Commodity Price Shocks on Underlying Inflation: The Role of Central Bank Credibility

  • Scott Davis

    (Federal Reserve Bank of Dallas and Hong Kong Institute for Monetary Research)

This paper seeks to document and explain the effect of a commodity price shock on underlying core inflation, and how that effect changes both across time and across countries. Impulse responses derived from a structural VAR model show that across many countries there was a break in the response of core inflation to a commodity price shock. In an earlier period, a shock to commodity prices would lead to a large and significant increase in core inflation, but in later periods, the effect was insignificant. To explain this, we construct a large-scale DSGE model with both headline and core inflation, and most significantly, a mechanism whereby fluctuations in inflation caused by purely transitory shocks can become incorporated into long-term inflation expectations. Inflation has a trend and a cyclical component. Private agents cannot distinguish between the two, so a cyclical fluctuation in inflation may be confused for a shift in the trend component. Bayesian estimation reveals that there was a change between the earlier and the later periods in the parameter that governs the anchoring of expectations. Impulse responses derived from simulations of the model show that this change in the effect of commodity prices on core inflation is driven by the change in the anchoring of inflation expectations.

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Paper provided by Hong Kong Institute for Monetary Research in its series Working Papers with number 272012.

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Length: 51 pages
Date of creation: Nov 2012
Date of revision:
Handle: RePEc:hkm:wpaper:272012
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