Tighter monetary conditions – not lower oil prices – are pushing down inflation expectations

Oil prices are tumbling and so are inflation expectations so it is only natural to conclude that the drop in inflation expectations is caused by a positive supply shock – lower oil prices. However, that is not necessarily the case. In fact I believe it is wrong.

Let me explain. If for example 2-year/2-year euro zone inflation expectations drop now because of lower oil prices then it cannot be because of lower oil prices now, but rather because of expectations for lower oil prices in the future.

2y2y BEI euro zone

But the market is not expecting lower oil prices (or lower commodity prices in general) in the future. In fact the oil futures market expects oil prices to rise going forward.

Just take a look at the so-called 1-year forward premium for brent oil. This is the expected increase in oil prices over the next year as priced by the forward market.

brent 1-year foreard

Oil prices have now dropped so much that market participants now actually expect rising oil prices over the going year.

Hence, we cannot justify lower inflation expectations by pointing to expectations for lower oil prices – because the market actual expects higher oil prices – more than 2.5% higher oil prices over the coming year.

So it is not primarily a positive supply shock we are seeing playing out right now. Rather it is primarily a negative demand shock – tighter monetary conditions.

Who is tightening? Well, everybody -The Fed has signalled rate hikes next year, the ECB is continuing to failing to deliver on QE, the BoJ is allowing the strengthening of the yen to continue and the PBoC is allowing nominal demand growth to continue to slow.

As a result the world is once again becoming increasingly deflationary and that might also be the real reason why we are seeing lower commodity prices right now.

Furthermore, if we were indeed primarily seeing a positive supply shock – rather than tighter global monetary conditions – then global stock prices would have been up and not down.

I can understand the confusion. It is hard to differentiate between supply and demand shocks, but we should never reason from a price change and Scott Sumner is therefore totally correct when he is saying that we need a NGDP futures market as such a market would give us a direct and very good indicator of whether monetary/demand conditions are tightening or not.

Unfortunately we do not have such a market and there is therefore the risk that central banks around the world will claim that the drop in inflation expectations is driven by supply factors and that they therefore don’t have to react to it, while in fact global monetary conditions once again are tightening.

We have seen it over and over again in the past six years – monetary policy failure happens when central bankers fail to differentiate properly between supply and demand shocks. Hopefully this time they will realized the mistake before things get too bad.

PS I am not arguing that the drop in actual inflation right now is not caused by lower oil prices. I am claiming that lower inflation expectations are not caused by an expectation of lower oil prices in the future.

PPS This post was greatly inspired by clever young colleague Jens Pedersen.

Leave a comment


  1. Do you differentiate between a negative demand shock and tighter monetary conditions? In your definition can monetary conditions stay equal while a negative demand shock occurs for example?

    Could changes in the energy market be the reason why increasing oil price expectations arent affecting inflation expectations? For example a transition into solar, hybrid cars etc…

    • Danny, in general I think of demand shocks and monetary shocks are the same thing. The Fed or any other central bank has the ability to control NOMINAL spending (and that is how I think of aggregate demand) in the economy either directly through creation of base money or indirectly through communications, which impacts money demand (money velocity) and the money-multiplier.

  2. Lawrence Kudlow

     /  October 14, 2014

    I tweeted you, Lars.

    Date: Tue, 14 Oct 2014 12:11:12 +0000 To: lkudlowny@hotmail.com

  3. Manuel

     /  October 14, 2014

    HI Chris…i disagree with you in this matter…i strongly believe that lower oil prices are the outcome of some strategical moves of the U.S in order to weaken Russian economy.The U.S increase their oil production and they have done multi-lateral agreement with Iran and Saudi Arabia in this respect:so this is really a supply shock but it is tied with the Ucraine’s crisis…so lower prices are not for all the commodities and probably are a short run move.This explain also the doom mood of the stock markets around the world(despite this positive supply shock) especially in Europe where the sanctions pose a drag on future growth(for Germany in particular)…sorry for the bad english

  4. Maurizio Colucci

     /  October 14, 2014

    So you don’t think a gold rally has begun in the last few days?

  5. Chris Papadopoullos

     /  October 14, 2014

    Why not reason both from and to the price change?. e.g Oil price falls due to negative demand from Europe and China. This is a positive supply shock to the UK.

  6. Lower oil prices today do lower TIPS spreads in the US, due to the lag in oil affecting the CPI, and also the lag in the CPI affecting TIPS returns.

  7. flow5

     /  October 20, 2014

    The rate-of-change in monetary flows (our means-of-payment money times its transactions rate-of-turn-over), peaked in May this year and bottoms in December this year (the proxy for inflation). The decline in the price of oil corresponds to the decline in aggregate monetary purchasing power (and coincides with some supply side gains).

  1. The Fed tightens and then is surprised with the outcome! | Historinhas

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