Oil price dynamics and market-based inflation expectations

Highlights: • We study the impact of oil prices on the 5- and 10-year market-based inflation expectations. • We use a nonlinear threshold ARDL model. • Oil prices positively impact inflation expectations, and more intensely above a threshold of 67 USD. • Oil prices have a nonlinear impact on the inflation risk premium. - Abstract: We examine the link between oil prices and market-based inflation expectations in the United States. Using a Gaussian affine term structure model, we decompose the breakeven inflation into three components: the market-based inflation expectations, the inflation risk premium and the liquidity risk premium. We show that oil prices have a nonlinear impact on the 5- and 10-year market-based inflation expectation components. Specifically, we find that the impact of oil price changes on inflation expectations is more intense when oil prices are above a threshold of 67 USD per barrel and is more pervasive for the intermediate term than for the longer term. Furthermore, we show that oil prices have a nonlinear impact on the inflation risk premium. These results have implications for the management of inflation expectations.