Corresponding author: Philipp Kartaev ( kartaev@gmail.com ) © 2019 Non-profit partnership “Voprosy Ekonomiki”.
This is an open access article distributed under the terms of the Creative Commons Attribution License (CC BY-NC-ND 4.0), which permits to copy and distribute the article for non-commercial purposes, provided that the article is not altered or modified and the original author and source are credited.
Citation:
Kartaev P, Medvedev I (2019) Monetary policy and the effect of the oil prices pass-through to inflation. Russian Journal of Economics 5(3): 1-1. https://doi.org/10.32609/j.ruje.5.47349
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The paper examines the impact of oil price shocks on inflation, as well as the impact of the choice of the monetary policy regime on the strength of this influence. We used dynamic models on panel data for the countries of the world for 2000–2017. It is shown that the impact of changes in oil prices on inflation is carried out predominantly through the channel of exchange rate. The paper demonstrates the influence of the transition to inflation targeting on the nature of the relationship between oil price shocks and inflation. This effect is asymmetrical: during periods of rising oil prices, inflation targeting reduces the effect of the oil prices pass-through, limiting the negative effects of shock. During periods of decline in oil prices, this monetary policy regime, in contrast, contributes to a stronger pass-through, helping to reduce inflation.
oil prices, inflation targeting, exchange rate, pass-through effect, monetary policy.
Oil price fluctuations may have a substantial impact on inflation. There are two channels for this impact identified in the literature: a direct channel, associated with changes in firms’ costs caused by the appreciation (or cheapening) of energy resources, and an indirect channel, the effect of which is determined by the foreign exchange rate pass-through in response to increasing or decreasing oil prices (see, e.g.,
The indirect impact channel of oil price changes on inflation has been analyzed in a number of papers on the pass-through effect of the foreign exchange rate (see, e.g.,
The effect of the direct channel, in turn, was tested in
Although we now know, on the whole, quite a lot about the consequences of inflation targeting (see, e.g.,
The goal of our paper is to fill this gap, that is, to find out how the transition to inflation targeting affects the nature of the connection between oil price fluctuations and inflation. This question seems especially important in the context of discussions around the policy pursued by the Bank of Russia, since, given Russia’s strong dependence on energy exports, the economy’s response to oil price shocks may remain quite strong.
This paper is structured as follows: part two contains a description of the data and the empirical strategy deployed; part three presents the results of our modelling and its interpretation; and the final part contains the results of the study.
We use a sample of 38 countries (11 developed and 27 developing ones) for the period from 1970 to 2017, corresponding to the inflation targeting regime today. Based on the type of inflation targeting, the countries analyzed can be divided into two groups: those using pure inflation targeting and those using mixed (hybrid) inflation targeting.
According to the approach used in
The main difficulty in obtaining a correct estimate of the impact of changing monetary policy is the shift caused by self-selection. As countries make independent decisions on transitioning to inflation targeting, these decisions may be associated with specific national characteristics. For example, it would be natural to expect that economies more strongly affected by inflation are more inclined to choose a monetary policy that would mitigate the inflation. In other words, the decision to switch to inflation targeting is endogenous, which may lead to an inadequate estimate of the respective model coefficient. To overcome this problem, we use a dynamic model based on panel data, and evaluated using the generalized method of moments. This enables us to, first, take into account inflation trends in the economy during previous periods; second, take into account country-specific effects; and third, make sure that endogeneity is removed through instrumental variables and subsequently testing their validity.
We use the following dynamic panel model:
ΔlnPit = φΔlnPit–1 + λΔlneit + βΔlneit ITit + θΔlnOPit + τΔlnOPit ITit + δXit + μi + εit, (1)
where the index i is the country, and t is the year; P is the consumer price index. Accordingly, ΔlnP is the logarithmic price growth rate, i.e. inflation. Adding to the right-hand part of the equation, the lagging value of the dependent variable reflects the inertial nature of inflation, attributable to the adaptive nature of inflation expectations for a portion of economic agents, which has been confirmed by a number of modern papers (see, e.g.,
In this kind of specification, the λ shows the instantaneous foreign exchange rate elasticity of prices (i.e. the pass-through effect of foreign exchange rate) in countries not targeting inflation. The sum of (λ + β) means similar elasticity for countries targeting inflation. In the same way, θ and (θ + δ) describe the passthrough effects of oil prices into domestic prices in countries which do not target and target inflation, respectively. In other words, they show the percentage increase in prices within the country as a result of a one-percent oil appreciation. For example, θ equal to 0.5 means that a 1% oil appreciation, all other conditions being equal, leads to an 0.5% increase in the general level of prices in countries that do not target inflation.
The specification we use relies on a wide range of publications regarding the impact of the foreign exchange rate pass-through into prices (see, e.g.,
The classification of countries based on their type of inflation targeting regime is taken from
The right-hand part of the equation contains previous values for the dependent variable, therefore we used the generalized method of moments in the evaluation. This is advisable, as ordinary models with fixed effects in this case result in inadequate coefficient estimates. We used inflation lags as tools according to the approach utilized by
The estimates obtained from equation modelling are given in Table
Estimates of the model’s basic specifications.
Parameter | Model 1, 2000–2017 | Model 2, 2000–2008 |
φ | 0.453*** (0.082) | 0.367*** (0.089) |
λ | 0.270*** (0.049) | 0.397*** (0.048) |
β | –0.148*** (0.053) | –0.148*** (0.053) |
θ | 0.004 (0.011) | 0.043* (0.026) |
τ | 0.015 (0.015) | –0.035 (0.021) |
Control variables | Yes | Yes |
Number of observations | 831 | 303 |
AR(1) | –2.70 [0.0069] | –2.16 [0.0306] |
AR(2) | –0.09 [0.9315] | –0.14 [0.8909] |
In all specifications, the estimated λ coefficient is significant, positive, and below one, confirming the partial impact of foreign exchange rate pass-through into consumer prices. In turn, the estimated β coefficient is always significant and negative, suggesting a reduced impact by foreign exchange rate pass-through as a result of switching to inflation targeting.
This result is extremely resistant to changes in the set of control variables for the subsample analyzed and the evaluation period, and correlates well with previous studies on the impact of the foreign exchange rate pass-through (
For the full sample, the estimated θ coefficient statistically insignificantly differs from zero for the period of 2000–2017, but is significant and positive for the period of 2000–2008 (when oil prices grew steadily). This is evidence of the presence of the oil prices pass-through effect to inflation when they are increasing. In addition, oil price fluctuations affect inflation not only directly but also indirectly, through changes in the foreign exchange rate caused by such fluctuations. This is evidenced by the significant impact of the foreign exchange rate pass-through.
The insignificance of the estimated τ parameter, i.e. the coefficient in the product ΔlnOPit ITit, can potentially be explained with one of two methods: (1) a change in monetary policy does not affect the correlation between oil prices and inflation, or (2) monetary policy is still important, but we cannot identify its effect due to the heterogeneity of the full sample. To find out which of the two explanations is closer to the truth, we focus on the effect of inflation price passthrough in developing countries. This makes the sample more homogeneous in terms of inter-country comparisons. We also break down the sample into two periods: 2000–2008 and 2011–2016. The first corresponds to a period of steady growth in oil prices; the second, to a period of decline.
This breakdown will help test the presence of asymmetry in the effect of price pass-through to inflation in accordance with the ideas laid down in
The modelling results for these subsamples are shown in Table
Estimates of the oil price pass-through impact for developing economies
Parameter | Model 3, 2000–2008 | Model 4, 2011–2016 |
φ | 0.405*** (0.082) | 0.637*** (0.006) |
λ | 0.380*** (0.038) | –0.425 (0.270) |
θ | 0.025 (0.018) | –0.012 (0.027) |
τ | –0.034* (0.020) | 0.064*** (0.017) |
Control variables | Yes | Yes |
Number of observations | 215 | 134 |
AR(1) | –2.26204 [0.0237] | –2.60064 [0.0093] |
AR(2) | 0.0696956 [0.9444] | 0.918297 [0.3585] |
To test the hypothesis that the choice between pure and hybrid inflation targeting may affect the oil price pass-through impact, we also estimated parameters for the following modification to the basic model:
ΔlnPit = φΔlnPit –1 + λΔlneit + βΔlneit ITit + θΔlnOPit + τΔlnOPit ITit + τ2 ΔlnOPit HYBit + δXit + μi + εit. (2)
The coefficient for the ΔlnOPitHYBit variable was close to zero and insignificant, therefore we must conclude that this choice does not affect the nature of the relationship between oil prices and the general price level in the economy. In other words, regulating the foreign exchange rate as part of inflation targeting does not produce additional advantages compared with a free-floating national currency in terms of changing the pass-through effect. This, however, does not contradict the fact that this regulation may affect other monetary policy performance characteristics, as shown in
The transition to inflation targeting affects the nature of the relationship between oil price shocks and inflation. We found evidence in favor of the effectiveness of the two channels of this impact:
Quantitative estimates show that the direct effect is comparatively small: for example, a 10% increase in oil prices under a stable foreign exchange rate causes the general price level in countries not targeting inflation to grow by approximately 0.3%. Whereas a 10% decline in the foreign exchange rate leads to 6% long-run growth in the general price level.
The empirical results obtained are quite consistent with the theory, according to which a correctly chosen monetary policy rule cannot only eliminate inflation shifts, but also ensure the optimal response of the central bank to exogenous shocks, neutralizing their negative impact on the economy (
Taking into account the considerable dependence of the Russian economy on energy price trends, these results can provide another argument in favor of the advisability of using a floating foreign exchange rate and inflation targeting in Russia (in addition to a mechanism for reducing the effect of external shocks such as a budget rule).
The reported study was funded by MGIMO-University, project number 1921-01-08.