Markets, oil and inflation: pricing the fear premium

Oil is never just oil: it has a unique place in macroeconomics. Like gold, it is not merely a commodity but a global macro-financial variable. When oil prices rise sharply, the debate quickly moves beyond the cost of the barrel. It becomes a question of inflation, central banks, discount rates and, ultimately, the valuation of risky assets. That is why renewed tensions around the Strait of Hormuz matter for markets and for economists alike. Developed economies are far less oil-intensive than they were in the 1970s, and central banks have gained credibility since then, but this does not make oil irrelevant to the investment puzzle. Investors’ and economic agents’ reactions matter to the pricing of oil risk across markets.

Today’s risk is not just that higher energy prices mechanically slow activity. It is that a persistent rise in oil prices changes the inflation narrative underpinning markets. In other words, investors may stop seeing oil as a relative-price shock and start treating it as a broader inflation problem. 

Our latest Simply put focuses on the gap between two things: the inflation impulse that can reasonably be attributed to an oil shock, and the broader ‘fear of inflation’ that can take hold of markets. If the fear premium rises, we question how much expected monetary tightening would be needed to bring markets back from fear to reason.

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What academic research tells us

Academic research offers a useful starting point to this question. As Lutz Kilian¹ showed, not all oil shocks are the same. An increase in oil prices driven by strong global demand differs in implication from one caused by supply disruption. The first can be a sign of a strong global economy. The second is more problematic: it acts like a tax on activity while also pushing inflation higher.

There is, however, a reassuring slant to the current situation that definitely falls under the category of a supply-side oil shock. As Olivier Blanchard and Jordi Galí² argued, an oil shock would not necessarily cause the same macroeconomic damage today as it did in the 1970s. Energy intensity is lower, wage indexation is less widespread and inflation expectations are better anchored. Modern economies should therefore be better equipped to absorb energy shocks.

But the research also carries a warning. Ben Bernanke, Mark Gertler and Mark Watson³ showed that part of the economic cost of oil shocks comes from the monetary policy response they trigger. In market language, an oil shock becomes dangerous when it is no longer treated as a relative-price shock but as a reason for central banks to stay restrictive for longer, as it ultimately lifts all prices together. 

That is the logic behind the empirical exercise below. First, we estimate the inflation fear premium and then investigate how monetary policy responds to it.

The inflation fear premium

Figure 1 illustrates the risk premium attached to a surge in inflation. The intuition is straightforward: markets can look through a short-lived rise in oil prices but struggle to ignore more persistent ones. When the price of oil keeps rising, investors do not merely revise their central inflation forecast but ask to be compensated for the risk that inflation will remain higher for longer. This is where inflation breakevens matter, alongside consumer inflation surveys: not only do they reflect expected inflation but also show a recurrent exaggeration, which can be termed as an ‘inflation fear premium’. The longer the oil shock lasts, the more credibility it acquires as a source of price pressure, leading this premium to rise.

FIG 1. Expected inflation vs rational one-year inflation expectations in the US⁴

Figure 1 uses a measure of expected inflation that combines a market-based component, inflation breakevens, with a survey-based component (the University of Michigan survey). Regressing this based on oil prices, a growth indicator and realised core inflation helps to differentiate between what can be considered reasonable inflation forecasts and what remains: inflation panic. 

The comparison is striking. For a year ahead, the model below suggests that a reasonable inflation expectation would be around 3%. Yet the combined measures of expected inflation are currently close to 4.5%. The implied inflation fear premium is therefore around 1.5%, which is significant.

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Central bank response

If the inflation fear premium rises, the reaction function of central banks is the next issue to consider. This is where macroeconomics can impact market pricing: a commodity shock becomes a rates shock if investors start to anticipate a central bank response. Figure 2 compares the expected change in Fed funds rates in six months to the inflation fear premium extracted from Figure 1. This should help measure how much markets see the Federal Reserve (Fed) changing rates over the coming months as a function of the inflation fear premium. 

The logic is simple: if inflation fear rises, markets should eventually price in a Fed response. Yet, the matter of how large that response might be is nuanced:

• First, over the long run, the response has been close to one-for-one. Since 1990, a 1% inflation fear premium has typically been associated with roughly a 1% increase in expected Fed rates
   
• Second, this relationship has weakened since 2010, and even more so since the COVID-19 pandemic. At the time of writing, markets expect the Fed to raise rates by only 25 basis points over the next six months, even though the inflation fear premium is close to 150 basis points. Before 2010, such a premium might have implied a Fed funds slope closer to 100 basis points. Today, the signal is far less clear.
   

With a new central banker at the helm of the Fed, it is difficult to say with any confidence that markets are underpricing future tightening. Part of the outcome will also hinge on uncertainty surrounding the Strait of Hormuz. Still, the message is important: if the oil shock proves less temporary than expected, the Fed funds curve may need to steepen and that is the risk investors should keep in mind as each additional day of disruption passes.

FIG 2. Inflation fear premium vs expected change in Fed rates priced by Fed funds markets⁵

Simply put, oil shocks tend to trigger an inflation fear premium that markets expect central banks to counter with tighter policy – a relationship that appears weaker today. 

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises is designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasting indicators currently show:

• Our world growth nowcaster has declined marginally. The ‘stag’ to stagflation impact is starting to show in macro data outside of the US
   
• Our inflation indicator has increased globally again: the progression of price pressures is gaining more visibility
   
• Similar to inflation, our monetary policy nowcaster also rose: inflation data is not yet strong enough to move the central bank needle, but the direction is no longer pointing towards more easing.

World growth nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).