Modelling economic policy issuesOil price shocks and inflation rate persistence: A Fractional Cointegration VAR approach
Introduction
Maintenance of a stable inflation rate is arguably the primal macroeconomic objective of every central banker, and a task that requires a proper understanding of inflation rate dynamics such as inflation rate persistence (see Tule et al., 2019). A proper understanding of the dynamics of inflation rate persistence helps central bankers in making appropriate monetary policy decisions (Amano, 2007, Coenen, 2007, Tetlow, 2019). Inflation persistence is the time it takes for shocks to inflation rate to die out (Sbordone, 2007). According to Bilici and Çekin (2020), it can also be defined as the speed with which inflation returns to its equilibrium level (long-term mean) after a shock. The effectiveness of monetary policy strategy is defined by its ability to achieve low inflation rate persistence, as this indicates that shocks to inflation rate are eliminated within a short period (Meller and Nautz, 2012, Gerlach and Tillmann, 2012, Bratsiotis et al., 2015). Sbordone (2007) further explained that the implementation of a stabilisation policy with a wrong inflation persistence estimate can be costly, particularly, when the policymaker is minimising a welfare-based loss function.
Oil price shock is one of the prominent external shocks that influence countries’ inflation rates (see Alvarez et al., 2011, Misati et al., 2013, Valcarcel and Wohar, 2013, Salisu et al., 2017, Sek, 2017, Lacheheb and Sirag, 2019, Nusair, 2019, Raheem et al., 2020). The potential effect of oil price shocks on countries’ inflation rates indicates that inflation rate persistence of countries may be affected by oil price shocks. This position is further justified by Misati et al. (2013) which found that the effect of oil prices on inflation is more persistent than the effect of food prices. As lower inflation rate persistence corresponds to the efficiency of monetary policy (Meller and Nautz, 2012, Gerlach and Tillmann, 2012, Bratsiotis et al., 2015), an increase in inflation rate persistence of a country, as a result of oil price shock, would imply weakness in the effectiveness of the monetary policy of such country, and call for a monetary policy review in the face of oil price shock. On the other hand, a reduction or no change in inflation rate persistence as a result of oil price shock would mean that the current monetary policy is responsive to oil price shock, and no monetary policy review is required in the face of oil price shock.
The main objective of this study is to investigate the effect of oil price shocks on inflation rate persistence, particularly focusing on top net exporters and importers of oil, which are highly prone to oil price shocks (Salisu et al., 2017, Raheem et al., 2020). This study is important, particularly for monetary authorities, in determining whether or not to review monetary policies in the face of oil price shocks. Respected monetary economist, Ben S. Bernanke, has called for caution in the review of monetary policy in the face of oil price shocks (see Bernanke et al., 1997). He argued that the economy may suffer from the effect of monetary policy if monetary policy changes were initiated against a transient oil price shock. This position has been confirmed by recent studies including Kormilitsina (2011) and Olubusoye et al. (2015). Specifically, Kormilitsina (2011) found that monetary policy amplified the negative effect of the oil price shock on the US economy, while Olubusoye et al. (2015) found that the adverse changes in the interest rate and exchange rate in Nigeria was due to change in monetary policy and not oil price shock. Thus, this study analyses the effect of oil price shocks on inflation persistence, to minimise the economic cost of initiating monetary policy actions when oil price shocks do not increase inflation rate persistence.
Methodologically, inflation persistence has been examined using a univariate modelling framework, such as the autoregressive, fractional integration and time-varying parameter approaches (see Pivetta and Reis, 2007, Noriega and Ramos-Francia, 2009, Gaglianone et al., 2018, Granville and Zeng, 2019, Bilici and Çekin, 2020) or a multivariate modelling framework, such as Johansen cointegration or fractional cointegration (see Mahdavi and Zhou, 1997, Niemann et al., 2013, Civelli and Zaniboni, 2014, Lucey et al., 2017, Aye et al., 2017, Yaya et al., 2019, Geronikolaou et al., 2020). While univariate models consider the idiosyncrasies of inflation rate, via its autoregressive coefficients, as being the sole determinant of inflation rate persistence; the roles of other factors are considered by multivariate models.
As appropriate, this study employs a multivariate modelling framework in analysing the effect of oil price shocks on inflation persistence. Specifically, it relies on the fractional cointegration VAR (FCVAR) approach introduced by Johansen (2008) and further expanded by Johansen and Nielsen (2010, 2012), as against the conventional cointegration VAR (CVAR) alternative by Johansen (1996). As both CVAR and FCVAR analyse the long-run relationship between or among variables, CVAR assumes only two fixed cases of long-run relationship (absence - short memory or presence - permanent memory); as indicated by zero and first orders of integration, I(0) or I(1), respectively). Whereas, FCVAR can assume varying orders of integration, I(d), where d indicates any real-value order of integration, which allows for long memory transitory persistence (see Gil-Alana et al., 2017, Gil-Alana and Carcel, 2018, Granville and Zeng, 2019).
The choice of FCVAR over the cointegration VAR (CVAR) alternative is motivated by two main reasons. First, several studies have found inflation rate to be fractionally integrated (see for example Granville and Zeng, 2019, Tule et al., 2019, Bilici and Çekin, 2020), while Gil-Alana and Gupta (2014) revealed that oil price is also fractionally integrated. This suggests that FCVAR would be a better approach in analysing the long-run relationship between oil price and inflation rate as involved in the analysis of oil price shock inflation rate persistence modelling. Second, studies have shown that the effect of oil price shocks on inflation rate has reduced in recent years (see Valcarcel and Wohar, 2013, Choi et al., 2018, Lahiani, 2018, Chen et al., 2020). FCVAR is, thus, appropriate, as oil price shock may be expected to only have a marginal effect on inflation persistence of countries. CVAR model relies on the assumption of large change in inflation persistence, which may result in wrong conclusion (see Tule et al., 2019).
This study contributes to the empirical literature on the analysis of the degree and the determinants of inflation persistence in three distinct ways. First, it examines the effect of an external factor (oil price) on inflation persistence using fractional cointegration VAR. The earlier attempt to apply FCVAR approach to inflation persistence analysis was made by Tule et al. (2019). However, the study only examines the fractional cointegration among components of inflation (food, energy, and core inflation), which are all domestic factors. Other studies on inflation persistence and domestic factors include Noriega and Ramos-Francia (2009) and Gaglianone et al. (2018). To the best of our knowledge, this study will be the first to account for the relationship between an external factor (oil price) and inflation persistence. This innovation was motivated by the need for monetary authorities to properly understand the nature of external shocks, in determining whether monetary policy intervention is required or not, in the face of oil price shocks (see Bernanke et al., 1997).
Second, this study accounts for the role of country-specific monetary policy frameworks and exchange rate regimes in modelling the effect of oil price shock on inflation persistence of the selected countries. The effect of monetary policy framework on inflation persistence has earlier been explained by Gerlach and Tillmann (2012). The study revealed that inflation targeting reduces inflation persistence. In like manner, the effect of exchange rate regime has been explained by Wu and Wu (2018), which found existence of higher inflation persistence under floating rates than under pegged rates. This study will contribute uniquely to the literature by accounting for the role of the two macroeconomic policies. This is considered important as recent studies have established the link between monetary policy framework (such as inflation targeting) and oil price shocks (see López-Villavicencio and Pourroy, 2019). Thus, this study will provide new evidence on the effect of oil price shock on inflation rate persistence under different monetary policy and exchange rate regimes.
Third, we investigate the existence and the role of oil price asymmetry in the oil price–inflation persistence relationship. Evidence from the recent studies revealed that inflation rate responds asymmetrically to changes in international commodity prices; indicating that the effects of positive and negative oil price shocks on inflation rate are different (see Salisu et al., 2017, López-Villavicencio and Pourroy, 2019, Nusair, 2019, Akinsola and Odhiambo, 2020, Raheem et al., 2020). Empirically, many studies have shown
that failure to account for asymmetry, when it exists and is significant, could lead to wrong conclusions (see for example Akdoğan, 2020, Salisu et al., 2017, Salisu et al., 2019). Thus, testing for asymmetry in oil price–inflation persistence, and accounting for same when it is significant, is expected to generate better empirical results. Asymmetry in the effect of oil price shocks on inflation persistence may imply that monetary authority would need to respond differently to positive and negative oil price shocks.
Following this introductory section, the remaining parts of the paper are organised as follows: Section 2 deals with literature review; some stylised facts and preliminary analyses are presented in Section 3; while Section 4 analyses the methodological framework for the study. Results and discussions are presented in Section 5, while Section 6 concludes the paper.
Section snippets
Literature review
Proper understanding of the nature and dynamics of a country’s inflation persistence is important for its apex monetary authority; particularly, as it aids the central bankers in making effective monetary policy decisions towards maintaining price level and economic stability (Bernanke et al., 1997). According to Sbordone (2007), inflation persistence is the time it takes for shocks to inflation rate to die out. It can also be defined as the speed with which inflation returns to its equilibrium
Stylised facts and preliminary analysis
In this study, we explore data for Brent oil price and inflation rate of top ten (10) oil-exporting and oil-importing countries, over the period between January 2000 and December 2019. The period covered generates 240 observations and includes the periods of high and low inflation rates in the selected countries. It, however, excludes the period of the recent COVID-19 pandemic, to avoid its possible distortionary effect. The selected countries were identified based on the recent ranking of
The model
Here, we provide a brief description of the method to be adopted in this study, drawing from two key studies that have proposed relevant methodologies to our study. These methods include: the conventional cointegration vector autoregressive [CVAR] model (Johansen, 1995) and the fractional cointegration vector autoregressive [FCVAR] model (Johansen and Nielsen, 2012). FCVAR has gained much popularity, as evident in its recent application in a variety of study areas (Jones et al., 2014; Gil-Alana
Results presentation and discussion
This section deals with the presentation and discussion of the empirical results of the study. It is sub-divided into four. The first sub-section deals with the analysis of the fractional cointegration among inflation rate, exchange rate and interest rate for inflation targeting and floating regime oil-exporting and oil-importing countries, and among inflation rate, exchange rate and external reserves for non-inflation targeting and pegged regime oil-exporting and oil-importing countries. This
Conclusion
Instituting monetary policy in reaction to oil price shock when the oil price shock does not constitute a threat to the economy has been explained to have adverse long-run effect on the economy (Bernanke et al., 1997, Kormilitsina, 2011). This study investigates oil price–inflation persistence relationship to analyse the effect of oil price shocks on inflation persistence of top ten (10) oil-exporting and oil-importing countries. It contributes to literature on the analysis of the degrees and
Declaration of Competing Interest
The authors declare that they have no known competing financial interests or personal relationships that could have appeared to influence the work reported in this paper.
Acknowledgements
The authors acknowledge the comments of the anonymous reviewers which have helped us significantly to improve the quality of this study. We also acknowledge the financial support of ILMA University, Karachi, Pakistan .
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