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The impact of oil price shocks on the UK: a time-varying SVAR

The impact of oil price shocks on the UK: a time-varying SVAR. Stephen Millard and Tamarah Shakir BOE, CAMA and MMF Workshop 25 May 2012. Motivation and Literature Data The model and the estimation process Step 1: identifying oil shocks Step 2: impact on the UK Results Conclusions.

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The impact of oil price shocks on the UK: a time-varying SVAR

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  1. The impact of oil price shocks on the UK: a time-varying SVAR Stephen Millard and Tamarah Shakir • BOE, CAMA and MMF Workshop 25 May 2012

  2. Motivation and Literature • Data • The model and the estimation process • Step 1: identifying oil shocks • Step 2: impact on the UK • Results • Conclusions The impact of oil price shocks on the UK Outline

  3. The impact of oil price shocks on the UK Motivation: Why care about oil shocks? Sharp oil price rises appear to be associated with world recessions. All but one of the US’ post-war recessions has been preceded by rise in oil price (Hamilton (1983)) Concern that oil price shocks may be ‘stagflationary’, worsens the policy-maker’s problem. Real oil price and world recessions

  4. And oil prices are volatile- since the 1970s, real oil price has repeatedly shown large (and persistent) fluctuations. The impact of oil price shocks on the UK Motivation: Why care about oil shocks? Real oil price changes

  5. Most studies focus on the US. Different sample periods, different measures of oil prices and changes but studies such as (Hamilton (1988 and 2000), Mork (1994), Bernanke, Gertler and Watson (1997) all find substantial negative effects on GDP and positive impacts on the level of prices. Some cross country studies- Jimenez-Rodriguez and Sanchez( 2004) , Peersman and Robays ( 2009)- find smaller effects for euro area than for the US. On-going debate about presence of asymmetric and non-linear effects. The impact of oil price shocks on the UK Literature: Headline impacts

  6. Not the focus of our work. But still a lot of debate about propagation of oil shocks, especially whether demand or supply channels dominate. • 3 mechanisms Hooker (2002) • Wealth effect- through terms-of-trade • Input price through production function • Relative price shocks requiring rebalancing across sectors The impact of oil price shocks on the UK Literature: How shock propagates

  7. Many studies also found evidence of decline in impact over time- specifically a break somewhere around 1986. (Hooker 2002) • Possible explanations: (1) the propagation of shocks has changed (the response) • Oil intensity of the economy has fallen • Policy responses have been better (2) The shocks have been smaller (the impulse) -look for asymmetric and non-linear responses The impact of oil price shocks on the UK Literature: Impact over time

  8. (3) the cause of the shocks has changed Often think of exogenous supply shocks generating large spikes, but if cause are shocks to global demand, then response of economy might be different. Key papers in this area • Kilian, L (2009), ‘Not all Oil Price shocks are alike’ • BaumeisterC, Peersman G and I Van Robays (2009) , ‘ The Economic Consequences of Oil Shocks: Differences across Countries and Time’ • Peersman G and I Van Robays (2009), ‘Oil and the euro area economy’ The impact of oil price shocks on the UK Literature: Cause of the shock

  9. Look at the impact on UK GDP, CPI and short-term interest rates. In contrast to US focussed studies. Identify three structural shocks to oil prices: oil supply, global demand, and oil-specific demand Explicitly model time-variation for both oil market and UK responses, using TVP-VAR as in Mumtaz and various (2008, 2009, 2011) The impact of oil price shocks on the UK Our question:

  10. Captures impact of three possible changes Changes in the structure of the oil market itself (how prices respond) General changes UK oil intensity and policy framework ...and... The impact of oil price shocks on the UK Our question: why time-varying?

  11. and, (3) for the UK , capture our transition from net oil exporter to importer The impact of oil price shocks on the UK Our question: why time-varying? UK crude oil trade balance (DECC)

  12. Had to keep the sets of variables manageable (≤4) to be able to actually run the TVP-VARs. So we split the process in two... 1. Oil VAR to model changes in oil price, identify three structural shocks 2. UK VAR plus world variables The impact of oil price shocks on the UK The model- 2 stage process overview

  13. Quarterly series from 1965-Q2 2011 Real, Sterling oil prices:UK Brent market price (IFS), RPI deflated World Oil production barrels per day:spliced series OPEC crude production 1965-1973, EIA world crude production World GDP index: OECD data 1965-1980, in-house PPP weighted series Datastream GDP data, IMF PPP weights (covers ≥75% world) UK GDP and UK RPI: ONS UK short-term interest rates All differences in natural logs The impact of oil price shocks on the UK Data

  14. The impact of oil price shocks on the UK The model- Step 1 Start with a reduced form VAR for the world oil market

  15. The impact of oil price shocks on the UK The model- Step 1: introducing time-variation Introduce time-variation

  16. The impact of oil price shocks on the UK The model- Step 1

  17. The impact of oil price shocks on the UK The model- Step 1

  18. Follow the notes from Applied Bayesian econometrics for central Bankers: Haroon Mumtaz and Andrew Blake. Want to draw βt (coefficients in the oil relationships)and aij,t (to then allow us to see the structural shocks ξt) Gibbs sampling approach – specifically the Carter-Kohn algorithm for draws of βt andaij,t and the M-H algorithm for stochastic volatility. The impact of oil price shocks on the UK The model- Step 1: Bayesian estimation

  19. Need some priors for initial states of βt and aij,t Use OLS estimation of fixed coefficient VAR for the first 20 observations (i.e. 1965-1970) And some priors for the hyper-parameters (Q, D and g) Q and D are assumed to be inverse Wishart: Use a small scalar on T0 ( so low weight on prior values) g is inverse gamma The impact of oil price shocks on the UK The model- Step 1: Bayesian estimation

  20. The impact of oil price shocks on the UK The model- Step 1

  21. The impact of oil price shocks on the UK The model- Step 1

  22. The impact of oil price shocks on the UK The model- Step 1

  23. Want to impose sign restrictions on the coefficients of A0 Follow Peersman and Roobays (2009) The impact of oil price shocks on the UK The model- Step 1: Identifying shocks

  24. The impact of oil price shocks on the UK The model- the shocks 0.22 0.01 0.002 0.001 0.002 0.02

  25. The impact of oil price shocks on the UK Oil price responses over time

  26. The impact of oil price shocks on the UK Oil price responses over time

  27. The impact of oil price shocks on the UK Oil price responses over time

  28. The UK VAR plus world variables The impact of oil price shocks on the UK The model- Step 2

  29. Repeat the estimation process from Step 1. Use first 20 observations to set priors etc. The impact of oil price shocks on the UK The model- Step 2 • To identify responses of UK variables to given structural oil shock, use a mapping from our stage 1 VAR responses of the world variables

  30. The impact of oil price shocks on the UK The model- Step 2: mapping Can re-write UK VAR as: Leaving a structural moving average representation (for responses of UK variables to unit shocks in world variables): And can then multiply through by the earlier responses of the world variables to identified structural shocks

  31. The impact of oil price shocks on the UK Results- Oil supply shock

  32. The impact of oil price shocks on the UK Results-World demand shock

  33. The impact of oil price shocks on the UK Results-Impact of oil price shocks on UK GDP after 4 quarters

  34. The impact of oil price shocks on the UK Results-Impact of oil price shocks on UK RPI after 4 quarters

  35. The impact of oil price shocks on the UK Conclusions- source of the shock matters • Oil supply shocks associated with larger negative impacts on UK output and positive impacts on inflation • Oil demand shocks associated with smaller, sometimes positive, effects on UK output and inflation. • Findings consistent with studies for other countries. But given UK is small relative to rest of world, finding was not clear a priori.

  36. The impact of oil price shocks on the UK Conclusions- time-variation in UK responses • Impact of oil supply shocks on output and inflation fell around the mid-1980s. And world oil market SVAR suggests that changes in world oil market (incl. vol of production) was important. • Also observed that UK variables became more sensitive to all types of oil shock after the mid-2000s. Not noted in other studies, and may be unique to UK transition from net exporter to importer.

  37. The impact of oil price shocks on the UK Questions

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