Oil prices in the real economy

Abstract

This paper presents a macro-finance model of the US economy and the spot and futures markets for oil. The performance of the model is greatly enhanced by using the Kalman filter to model latent variables representing the inflation asymptote, the real price of oil and the slope of the futures curve. We find that these are dominated by innovations in observed futures prices, reflecting the importance of market expectations. Using the Kalman filter to capture inflationary shocks helps solve the notorious price puzzle, the tendency for increases in interest rates to anticipate such developments and apparently cause inflation. Futures prices also depend upon risk premiums, which we find are dominated by the latent variable representing the real oil price rather than macro variables like inflation and interest rates.