Oil Futures Prices, Inflation Expectations, and Bond Risk Premiums

Abstract

By decomposing West Texas Intermediate futures price changes into structural supply and demand shocks, this paper shows that dissecting the oil price significantly improves inflation forecasts. Empirically, demand-driven shocks predict a negative real bond risk premium but a positive inflation risk premium; these opposing effects result in an insignificant net effect on the nominal bond risk premium. A two-sector New Keynesian model formalizes the dynamics among oil shocks, inflation, and bond yields, reconciling two distinct historical episodes: anchored inflation during the 2000s oil crisis and the surge in tandem with oil prices following the 2022 Russian invasion of Ukraine.