An investigation of the two-way relationship between commodities and the UK economy in an environment of inflation targeting

This study investigates the sensitivity of the relationship between oil industrial inventories and oil supply at national, international and global levels to developments in monetary policy in the UK. More specifically, it provides evidence for the UK about the two-way relationship between monetary policy and commodity markets in an environment of inflation targeting. The importance of this research can be found in the provision of information which may be beneficial when projecting the economic outlook in general and inflation forecasts in particular. Although the UK operates under an inflation targeting framework, where supply shocks are considered as short-term, but recent movements in commodity markets are found to be more persistent, this study also investigates whether the sensitivity of the UK economy and policy makers to unanticipated movements in commodity prices has changed since the peak in commodity prices in 2008 which is coincident with the start of the financial crisis.

The estimation of VEC models adjusted for the UK, and plotting impulse response functions is used to investigate the dynamic reaction of oil inventories and oil supply at national, international and global levels to the shock in monetary policy. Estimated SVAR models investigate the size of the persistent and transitory effects of different types of oil and food commodity shocks on the UK economy and the reaction of policy makers. Afterwards, the

Chow test is used for the identification of potential structural breaks and the investigation of whether the sensitivity of the UK economy to shocks in commodity prices has changed.

The results reveal that an expansionary UK monetary policy leads to a statistically significant decline in the OPEC oil supply while there is a less statistically significant effect on EU oil supply movements. Tight monetary policy is found to have the most significant effect on the UK’s industrial oil stocks and EU industrial oil stocks. The results also reveal that the world oil supply, as well as the OPEC oil supply, became less responsive to money supply and more responsive to interest rates after the Bank of England was given an operational independency. The responsiveness of the OECD oil stocks has also become slightly more responsive since the financial crisis. Following an investigation of the transitory and persistent effect of oil and food commodities shocks in relation to the nature of the shocks, the results reveal that shocks in oil prices pass through into the UK’s core inflation. It is also found that policy decisions in the UK are more sensitive to the actual shock in food prices than to the primary shock in food demand. The response of headline inflation to oil price shocks is found to be stronger before the oil price peak in 2008 and becomes less responsive afterwards while the response of core inflation to the shock in food prices is stronger after the price peak in 2008.