Correlation Structure between Inflation and Oil Futures Returns: An Equilibrium Approach

We use a general equilibrium model of a monetary economy to understand the economics behind the correlation between in nation and oil futures returns. Oil is used as both, an input to the production of capital and as a consumption good. We estimate our model using maximum likelihood with the following datasets: crude oil futures prices, nominal interest rates, in nation rates and money supply growth rates. We nd that some of the positive correlation found in empirical studies is due to the fact that oil is in the consumption basket; however, this accounts only for a minor part of it. There exist other important sources of correlation related to monetary shocks and output shocks. In particular, we nd that the correlation is extremely sensitive to the reaction of the central bank to output shocks, while the reaction to in nation changes is less signi cant. Our estimates suggest that the monetary authority overreacts to output shocks by increasing the money supply in a more than necessary amount, generating a signi cant source of positive correlation. From a practical perspective, We nd that it is a good strategy to use as a hedge, the futures whose maturity is closer to the hedging horizon. This is particularly true for short-term hedging.