In the 1970s, high inflation rates followed large increases in oil prices. This may have contributed to the perception that oil prices drive inflation. But what effects do oil prices actually have? A recent Economic Synopses essay examined the connection between oil prices and inflation.
Assistant Vice President and Economist Christopher Neely noted that economists generally agree that oil prices can drive some variation in inflation in the short and medium term, while central banks can offset oil price shocks over the long term.
Financial markets, however, seem to react strongly to changes in oil prices, as shown by changes in breakeven inflation rates in the face of changes in oil prices. One way to calculate breakeven inflation rates (which can serve as a measure of what the market expects inflation to be) is by comparing the yields of Treasury inflation-protected securities, or TIPS, with Treasury bonds of similar maturity that don’t have payouts that depend on inflation.
Neely noted that the correlation between the daily changes in breakeven inflation and West Texas Intermediate spot oil prices was positive and substantial over the period 2004-15. A 50 percent reduction in oil prices would reduce expected inflation by 0.27 percentage points per year over 10 years.
However, inflation is difficult to predict, and Neely noted that studies have shown that oil prices seem to pass very little through to inflation. He wrote, “For example, Chen’s (2009) estimates with quarterly data predict that a 50 percent decrease in oil prices would reduce the overall price level by less than 0.19 percent, which is far less than the change implied by financial markets.”1
Neely concluded that the difference between these two outcomes is puzzling to explain. He wrote, “Perhaps financial market participants systematically overestimate the importance of oil prices, or perhaps the econometric studies fail to accurately measure pass-through and oil prices do heavily influence inflation. Or perhaps there is another explanation, such as breakeven inflation causing changes in oil prices. But it is a mystery.”
1 Chen lists the short-run pass-through for the United States in his Table 3 as 0.00372, so 0.5 x 0.00372 = 0.186%. Chen, Shiu-Sheng. “Oil Price Pass-Through into Inflation,” Energy Economics, January 2009, Vol. 31, No. 1, pp. 126-33.