Title: Have Rising Oil Prices Become a Greater Threat to Price Stability
Abstract: (ProQuest: ... denotes formula omitted.)The effect of oil prices on inflation has varied considerably over the last 50 years. In the 1970s and early 1980s, oil price increases were associated with high and rising inflation. In the late 1980s and 1990s, however, the effect of oil prices on inflation appeared to moderate. While the experience of the earlier period is unlikely to be repeated today because of a better anchoring of long-term inflation expectations, recent evidence suggests oil prices again may be playing a more significant role in the inflation process.This article argues that the pass through of oil price changes to inflation-though still low when compared with the 1970s and 1980s-has increased in the last five years. In particular, the average effect of oil prices on inflation today is about double what it was in the early 2000s. One explanation is that consumer spending on petroleum and petroleum products as a share of total spending, which fell in the 1990s, has increased to levels last observed in the 1970s. Other possible explanations include the financialization of commodity markets and the highly accommodative stance of monetary policy associated with the global financial crisis of 2008-09.Section I explains how changes in oil prices affect inflation. It then presents evidence on, and explanations for, the more moderate effect of oil prices on inflation in the 1990s. Section II shows that the effect of oil prices on inflation, though still muted, has increased since the mid- 2000s. The section then provides possible explanations.I. OIL PRICE PASS THROUGH AND THE GREAT MODERATIONSharp increases in oil prices typically cause inflation to rise. The extent and persistence of the increase in inflation depends on how inflation expectations respond to the increase in oil prices. In the 1970s and early 1980s, oil price increases were associated with rising inflation expectations, which in turn contributed to a large and persistent increase in inflation. In the 1990s, inflation expectations held relatively steady when oil prices rose, and inflation remained relatively low and stable.The channels of oil price pass through to inflationThe U.S. economy relies extensively on fossil fuels-petroleum, in particular. According to the U.S. Energy Information Administration, 37 percent of the energy consumed in the United States comes from petroleum. Of the petroleum consumed, 72 percent is used in transportation and the rest is used as inputs in sectors such as agriculture, construction, manufacturing, food processing, and pharmaceuticals (Monthly Energy Review, June 2011). Because of the pervasive role of oil in the economy, oil prices affect the prices of many goods and services as well as the general price level. Moreover, oil price increases have the potential to increase inflation. The increase in inflation caused by an increase in oil prices is referred to as the pass through of oil prices to inflation.In general, the impact of oil price movements on consumer prices can be broken into first-round and second-round effects. First-round effects mainly reflect the impact of oil prices on the prices consumers pay directly for energy products, such as gasoline and home heating oil. Supply and demand in the consumer market for energy are largely inelastic because there are few, if any, alternatives that consumers and producers can substitute for oil in the short run. Changes in crude oil prices are, therefore, almost immediately and completely passed on to retail consumer energy prices. The first-round direct effects are often large but mostly short-lived.In addition to these direct first-round effects, oil prices indirectly affect the prices of consumer goods and services that use petroleum or petroleum products in their production. Assuming other input prices are slow to adjust, an increase in oil prices will cause the prices of goods and services that use petroleum or petroleum products as inputs (such as asphalt roof shingles or public transportation) to rise because production and operating costs will increase. …
Publication Year: 2011
Publication Date: 2011-09-22
Language: en
Type: article
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Cited By Count: 5
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