State-dependent oil price shocks on inflation and the efficacy of inflation targeting regime

Abstract

This paper investigates the state-dependent effect of oil price shocks on domestic inflation using a panel of 30 countries over the period of 2001Q3 to 2022Q4. We find a significant asymmetric effect over different economic states, with a positive and significant effect during economic boom periods, while no significant effect during bust periods. Such state-dependent effect is also quantitatively verified through a dynamic panel threshold framework. As a related question, the paper also examines the effectiveness of inflation targeting (IT) regime in adjusting the oil price shocks-induced inflation. We evaluate the effectiveness of IT regime from several dimensions: whether it contributes to reducing 1) the level of inflation induced by oil price shocks during boom periods, 2) the probability of oil price shocks-induced inflation deviating from inflation target range, and 3) the duration of inflation deviations from the target range. Our findings indicate that central banks under inflation target regime do not mitigate the level and volatility of inflation induced by oil price shocks more effective than the Non-IT regime. Nevertheless, it reduces the duration of oil price shocks-induced inflation that is above the upper limit of target range. As for the causes, our findings suggest that inflation-targeting central banks do not react aggressively to oil price shocks during economic expansions so as to maintain the positive momentum of economic growth and employment, rather than immediately curbing inflation.