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

2. Outline 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 May 20122

3. Motivation: Why care about oil shocks? The impact of oil price shocks on the UK May 20123 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. Motivation: Why care about oil shocks? 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 May 20124 Real oil price changes

5. Literature: Headline impacts 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 May 20125

6. Literature: How shock propagates 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 May 20126

7. Literature: Impact over time 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 May 20127

8. Literature: Cause of the shock (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’ Baumeister C, 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 May 20128

9. Our question: 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 March 20129

10. Our question: why time-varying? Captures impact of three possible changes (1)Changes in the structure of the oil market itself (how prices respond) (2)General changes UK oil intensity and policy framework...and... The impact of oil price shocks on the UK March 201210

11. Our question: why time-varying? and, (3) for the UK, capture our transition from net oil exporter to importer The impact of oil price shocks on the UK March 201211 UK crude oil trade balance (DECC)

12. The model- 2 stage process overview 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 March 201212

13. Data 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 March 201213

14. The model- Step 1 The impact of oil price shocks on the UK May 201214 Start with a reduced form VAR for the world oil market

15. The model- Step 1: introducing time-variation The impact of oil price shocks on the UK March 201215 Introduce time-variation

16. The model- Step 1 The impact of oil price shocks on the UK March 201216

17. The model- Step 1 The impact of oil price shocks on the UK March 201217

18. The model- Step 1 The impact of oil price shocks on the UK March 201218

19. The model- Step 1: Bayesian estimation Follow the notes from Applied Bayesian econometrics for central Bankers: Haroon Mumtaz and Andrew Blake. Want to draw β t (coefficients in the oil relationships) and a ij,t (to then allow us to see the structural shocks ξ t) Gibbs sampling approach – specifically the Carter-Kohn algorithm for draws of β t and a ij,t and the M-H algorithm for stochastic volatility. The impact of oil price shocks on the UK March 201219

20. The model- Step 1: Bayesian estimation Need some priors for initial states of β t and a ij,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 T 0 ( so low weight on prior values) g is inverse gamma The impact of oil price shocks on the UK March 201220

21. The model- Step 1: C-K algorithm The main steps are: 1.Conditional on A t, H t and Q, draw β t. Use β t draw to calculate residuals forand draw from Q and D. 2. Using β t,H t and Q, (and D 12 ) and D 2 draw a ij, t and calculate residuals and then calculate 3. Can draw for h i,t 4.Run this 100,000 times and burn the first 99,000 The impact of oil price shocks on the UK March 201221

22. The model- Step 1 The impact of oil price shocks on the UK March 201222

23. March 2012 The impact of oil price shocks on the UK 23 The model- Step 1

24. March 2012 The impact of oil price shocks on the UK 24 The model- Step 1

25. The model- Step 1: Identifying shocks Want to impose sign restrictions on the coefficients of A 0 Follow Peersman and Roobays (2009) The impact of oil price shocks on the UK March 201225 Structural shocks Oil production, Q oil Oil price, P oil World demand, Y wld Oil supply<0>0≤0 World demand >0 Oil specific demand >0 ≤0

26. March 2012 The impact of oil price shocks on the UK 26 The model- the shocks Oil productionWorld GDPWorld prices Oil supply shockWorld demand shockOil demand shock 0.22 0.01 0.001 0.02 0.002

27. The model- Step 1 The impact of oil price shocks on the UK March 201227 If we consider our reduced-form VAR in the structural form..., Relate the reduced form and structural to get R t

28. Oil price responses over time The impact of oil price shocks on the UK March 201228

29. Oil price responses over time The impact of oil price shocks on the UK March 201229

30. Oil price responses over time The impact of oil price shocks on the UK March 201230

31. The model- Step 2 The UK VAR plus world variables The impact of oil price shocks on the UK March 201231

32. The model- Step 2 Repeat the estimation process from Step 1. Use first 20 observations to set priors etc. The impact of oil price shocks on the UK March 201232 To identify responses of UK variables to given structural oil shock, use a mapping from our stage 1 VAR responses of the world variables

33. The model- Step 2: mapping The impact of oil price shocks on the UK March 201233 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

34. Results- Oil supply shock The impact of oil price shocks on the UK March 201234

35. Results-World demand shock The impact of oil price shocks on the UK March 201235

36. Results-Oil demand shock The impact of oil price shocks on the UK March 201236

37. Results- Impact of oil price shocks on UK GDP after 4 quarters The impact of oil price shocks on the UK March 201237

38. Results- Impact of oil price shocks on UK RPI after 4 quarters The impact of oil price shocks on the UK March 201238

39. Results- Average results 1976-2011 The impact of oil price shocks on the UK March 201239 Average impact on UK GDP after 4 quarters Oil supply shock World demand shock Oil demand shock 1976-2011 0.20.4 1976-1985 -2.1 0.70.2 1986-2003 -0.40.00.3 2004-2011 -0.80.01.0 Average impact on UK RPI after 4 quarters 1976-2011 0.90.1-0.3 1976-1985 2.1-0.2-0.7 1986-2003 0.30.10.3 2004-2011 0.60.50.6

40. Results- Average results 1986-2011 The impact of oil price shocks on the UK March 201240 Baumeister et al results (2009) sample period of 1986-2008Q1 UK TVP-SVAR results (average 1986-2011) US GDPUS CPIEA GDPEA CPIUK GDPUK RPI Oil supply-0.3+0.4-0.3+0.6-0.5+0.4 World demand+0.3+0.6+0.3+0.70+0.1 Oil demand-0.4+0.5-0.4-0.6+0.5-0.1

41. Conclusions- source of the shock matters The impact of oil price shocks on the UK March 201241 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.

42. Conclusions- time-variation in UK responses The impact of oil price shocks on the UK March 201242 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.

43. Questions The impact of oil price shocks on the UK March 201243