What Is the Relationship Between Oil Prices and Inflation?

Oil prices and inflation have a cause and effect relationship

Fact checked by Vikki VelasquezReviewed by Gordon ScottFact checked by Vikki VelasquezReviewed by Gordon Scott

Crude oil is a major economic input, so a rise in oil prices contributes to inflation, which measures the overall rate of price increases across the economy.

Inflation as measured by the annual gain in the U.S. Consumer Price Index (CPI) set a 40-year high in March 2022 amid COVID-19 supply disruptions. Crude oil prices were the highest in a decade as the U.S. and its allies imposed sanctions on Russia due to its invasion of Ukraine.

Key Takeaways

• Higher oil prices contribute to inflation directly and by increasing the cost of inputs.
• There was a strong correlation between inflation and oil prices during the 1970s.
• Oil’s potential to stoke inflation has declined as the U.S. economy has become less dependent on it.
• Oil prices exert a greater influence on producer prices because of oil’s role as a key input.
• Some argue that costly renewable energy could re-strengthen the correlation between energy costs and a higher inflation rate.

Cause and Effect

Energy accounted for about 7.3% of the CPI as of December 2021, including the index weighting of about 4% for energy commodities.

In addition to that direct effect on inflation, higher oil prices raise inflation indirectly because crude oil is a key ingredient in petrochemicals used to make plastic. So, more expensive oil will tend to increase the prices of many products made with plastic.

Similarly, consumer prices factor in transportation costs, including fuel prices, and the cost of oil accounts for roughly half of the retail price of gasoline.

The indirect contributions of crude oil prices to inflation are reflected in the core CPI index, which does not include energy or food prices because they tend to be more volatile.

Federal Reserve Chair Jerome Powell said in his semiannual testimony before the U.S. Senate Banking Committee in March 2022 that, as a rule of thumb, every $10 per barrel increase in the price of crude oil raises inflation by 0.2% and sets back economic growth 0.1%.

A study by the Federal Reserve Bank of Dallas in September 2021 suggested that if crude oil prices rose to $100 per barrel for three months before retreating, the spike would boost the annual inflation rate by 3 percentage points in the short term, with the effect fading quickly as oil prices pulled back.

Important

Oil prices hit decade highs in March 2022 in response to Russia’s invasion of Ukraine and the subsequent U.S. ban on imports of Russian oil.

Shifting Trends

Crude oil was a bigger contributor to inflation in the 1970s, when it was used much more intensively per unit of economic output. Back then, the U.S. economy consumed more than a barrel of crude per $1,000 of gross domestic product. By 2019, that had dropped to about 0.4 barrels per $1,000 of GDP.

Reduced reliance on energy, and in particular crude oil, promoted disinflation, or the decline in the inflation rate.

Spot oil prices have retained a strong correlation to market measures of long-term inflation expectations, however.

Some analysts have argued that the recent correlation between crude’s diminished importance as an economic input and a lower inflation rate may no longer hold as oil is supplemented by less climate damaging but more expensive renewable energy sources and global supply chains give way to costlier domestic or regional sourcing.

Goods Producers Pay the Price

Historically, oil prices have exerted more influence on the Producer Price Index (PPI), which measures the prices of goods at the wholesale level, than the CPI, which measures the prices consumers pay for goods and services.

Between 1970 and 2017, the correlation between oil prices and the PPI was 0.71. That’s much stronger than the 0.27 correlation with the CPI, according to the Federal Reserve Bank of St. Louis.

“The weaker link between oil prices and consumer prices likely comes from the relatively higher weight of services in the U.S. consumption basket, which you’d expect to rely less on oil as a production input,” according to the St. Louis Fed.

The Federal Reserve’s preferred inflation measure, the personal consumption expenditures price index, has a lower gasoline weighting than the CPI.

Is Inflation Good or Bad for Oil Prices?

It depends on the time frame. In the short term. higher inflation tends to lead to higher oil prices. In the longer term, if the Federal Reserve raises interest rates and slows economic growth to control inflation, oil prices could decline as a result.

What Type of Inflation Would Be Triggered by an Increase in Oil Prices?

Oil prices have historically had a greater impact on the Producer Price Index (PPI) than on CPI. PPI measures the price of goods at the wholesale level.

What Other Factors Can Cause Oil Prices to Rise?

In addition to the demand for oil to produce a host of products plus its use by the transportation industry, other factors that can cause oil prices to rise include geopolitical tensions, tight supply, and growing economic strength.

The Bottom Line

While the price of oil has historically correlated with inflation, that relationship has become less pronounced since the 1970s. The loosening of this correlation is likely a result of the growth of the service sector which uses energy less intensively than manufacturing.

Since oil is a key input in manufacturing and a major cost factor in shipping, oil prices have tended to have a greater effect on the cost of goods than services, which also explains the relatively weak correlation between oil and CPI and the strong one between crude and PPI.

Read the original article on Investopedia.