Modelling Dynamic Relationships Between Energy Prices and Inflation in Euro Area Using Wavelets

In this chapter, we investigate the relationship between energy prices, economic uncertainty, and inflation in Eurozone countries. To account for cyclicality in the business cycle, the level of industrial production is also considered. We propose a wavelet time-varying VAR model to assess the transmission of shocks across different time scales. The main findings of this analysis can be summarized as follows. First, a significant correlation is found between energy prices and inflation. Statistically significant periods of high correlation are detected primarily during times of turmoil, such as the 9/11 terrorist attacks, the U.S.-led invasion of Iraq in 2003, the Global Financial Crisis, and the sovereign debt and banking crises. Notably, high coherence levels are observed across all frequencies following the onset of the COVID-19 pandemic and the Russian invasion of Ukraine in February 2022. Second, the impact of uncertainty shocks on energy markets appears to be persistent. Third, energy prices serve as important shock transmitters, although the magnitude of this transmission varies over time and across different frequencies. Specifically, our estimation results suggest that energy price shocks are transmitted to both industrial production and inflation, with the impact being most noticeable around eight months after the initial shocks. These results imply that while there is a pass-through effect, the transmission of energy price shocks to the economic system in the Eurozone is relatively slow.