The influence of oil investors' sentiment on inflation dynamics and uncertainty

Abstract

In recent years, inflation has surged significantly, and uncertainty surrounding energy prices has increased worldwide. This uncertainty, which has led to demand shocks during the post-pandemic recovery phase and has been exacerbated by recent geopolitical tensions, has impacted investor behaviour, leading to shifts in investment strategies and market sentiment. This study aimed to explore the connection between these two trends by examining whether investor sentiment related to oil markets affects inflation in the European Union (EU) utilising a comprehensive dataset and advanced econometric techniques. Our findings reveal that oil sentiment significantly affects inflation, with implications for both demand and supply dynamics. A positive relationship is observed between oil sentiment and headline Harmonised Index of Consumer Prices (HICP) inflation, and a negative relationship between oil volatility and inflation over a 12-month horizon. Additionally, our findings reveal that a model incorporating fundamentals and oil sentiment provides superior forecasting performance for EU inflation, suggesting that oil sentiment offers valuable insights into the future behaviour of EU inflation. Finally, our results demonstrate that EU inflation reacts positively and significantly to a positive oil sentiment shock only during low-sentiment periods, whereas an insignificant response is observed during high-sentiment periods. Our study highlights the importance of incorporating investor sentiment into policy frameworks, suggesting that understanding these psychological factors can enhance inflation management strategies. Overall, this research contributes to a deeper understanding of the complex interplay between investor sentiment and macroeconomic variables, offering valuable insights for policymakers and investors alike.