Why should the price of oil affect US inflation?

Sudden rise in inflation as a result of base effects and a rise in oil prices

In December 2016, the consumer price index in Germany increased by 1.7% compared to the same month of the previous year. This represents a significant increase in the inflation rate, which has averaged just 0.3% since January 2015 and was still 0.8% in October and November 2016. The sharp rise is mainly due to the energy prices, which have recently risen noticeably. At the same time, a base effect comes into play, as the price level had fallen in the same period of the previous year in the wake of the decline in the oil price at the time. The Institute for the World Economy (IfW) also anticipates significantly higher inflation rates in 2017 than in the previous two years due to the renewed rise in energy prices.1 However, inflation is likely to fall below its current level again over the course of the year, with the fluctuations significantly increasing the development of the oil price during the year will be due.

The decline in the oil price in particular has shaped the inflation picture over the past two years (see Figure 1). The price of a barrel of Brent crude, which was still US $ 110 in mid-2014, fell to below US $ 50 in January 2015. The subsequent rise was only temporary; Another price slide caused the oil price to drop to around US $ 30 in January 2016. Since this low point, prices have risen again. In December, the oil price was over US $ 50, again surpassing the previous year's value.

illustration 1
Oil price
Price of the Brent variety in US dollars per barrel

Sources: Intercontinental Exchange: London Brent Index and Futures Data via Thomson Reuters; Energy Information Administration (EIA): Short-Term Energy Outlook; own prognosis.

As a result of this development, the energy component had a major drag on the inflation rate in the last two years (see Figure 2). On average, energy prices fell by around 6.5% in these years compared to the previous year. However, core inflation adjusted for the energy component was also somewhat weaker recently. At the beginning of 2014 this was still just under 2%, but then fell and has remained relatively stable at around 1.2% since then. The prices developed differently in individual areas. While food, messaging and housing prices2 fell for long stretches, alcohol and tobacco, hospitality and health care were the main upward pressures on general inflation.

Figure 2
Consumer price index and energy prices
Change compared to the previous year in index points, no
seasonally adjusted

Sources: Federal Statistical Office.

The core rate of inflation does not remain completely unaffected by changes in the oil price, as these also have indirect effects in addition to their direct influence on consumers' energy costs. On the one hand, this can lead to an adjustment in the prices of energy-intensive products (indirect first-round effect). On the other hand, the short-term depressed or increased inflation caused by the oil price can influence price and wage-setting behavior (second-round effect).

However, there is some uncertainty about how elastically the core rate will actually respond to the oil price. In studies for the euro area, the European Central Bank (ECB) comes to the conclusion that these indirect effects are significant and account for an estimated one-third of the inflationary effect of a change in oil prices.3 Ducrozet and Gharbi4, on the other hand, calculate significantly lower indirect effects.5 You note that that the elasticity of core inflation in relation to percentage changes in the oil price depends on its level and is lower when the oil price is low, and that structural factors such as the falling oil intensity in production and the stronger anchoring of inflation expectations have probably further reduced the indirect effects over time. The experiences of the recent past, in which strong oil price fluctuations were accompanied by a fairly constant core rate, speak in favor of the thesis of lower indirect effects. If this is correct, it would now be assumed, conversely, that the core rate will only react cautiously to the recent recovery in the oil price. However, the degree of utilization of the production capacities in this country is already quite high and will probably continue to increase. Overall, the core rate of inflation should therefore gradually turn out to be higher.

The external value of the euro has hardly given any impetus to price developments recently. The nominal-effective devaluation at the beginning of 2015, which went hand in hand with the entry of the European Central Bank into its bond purchase program, did not last. In 2016, the external value of the euro remained largely constant, as changes in exchange rates against individual currencies largely offset each other. The individual exchange rates apparently also depend on the different orientations of the monetary policy of the respective central banks. While the US dollar appreciated in the final months of last year, as a gradual tightening of monetary policy is to be expected in the US against the background of an expected expansionary fiscal policy, the British pound gained significantly as a result of the Brexit decision in mid-2016 after, also because the Bank of England responded with a more expansionary policy path.

The noticeable increase in the price of oil last December is probably due not least to the announcement by the OPEC states and other oil-exporting countries that they want to cut production. Should these plans be implemented, there would probably be a significant excess demand on the oil market, so that stocks would quickly decline. However, the past has shown that the quotas agreed by OPEC are not fully complied with by its members due to the lack of sanction mechanisms.6 In the December forecast, the IfW therefore assumed - similar to the Energy Information Administration - that the oil price path would only rise moderately in the near future . The current prices of Brent futures contracts also do not point to a further rapid rise in the price of oil.

Salomon Fiedler
[email protected]

  • 1 J. Boysen-Hogrefe, S. Fiedler, D. Groll, N. Jannsen, S. Kooths, M. Plödt, G. Potjagailo: German economy on course for expansion, in: Kieler Konjektivenberichte, Q4, 2016.
  • 2 In addition to the low energy costs, this could also be due to the successive revision of the rental sample. Between the beginning of 2015 and the beginning of 2017, this process can contribute to a signing of the actual rental price dynamics, as the sample proportion of small landlords and rural regions, which tend to have lower rental prices, is increased (see also joint diagnosis: German economy well utilized - realign economic policy, autumn 2016, p. 41).
  • 3 ECB: Oil Prices - Their Determinants and Impact on Euro Area Inflation and the Macroeconomy, in: ECB Monthly Bulletin, August 2010, https://www.ecb.europa.eu/pub/pdf/other/art1_mb201008en_pp75-92en.pdf (9.1.2017); ECB: Indirect Effects of Oil Price Developments on Euro Area Inflation, in: ECB Monthly Bulletin, December 2014, https://www.ecb.europa.eu/pub/pdf/other/mb201412_focus03.en.pdf (9.1.2017) .
  • 4 F. Ducrozet, N. Gharbi: Euro Area: Little evidence of large second-round effects of oil on core inflation, 2016, http://perspectives.pictet.com/2016/01/22/euro-area-little- evidence-of-large-second-round-effects-of-oil-on-core-inflation / (9.1.2017).
  • 5 For comparison: For the exchange rate weighted according to trade intensity, they calculate an elasticity that is three to four times as high.
  • 6 K.-J. Gladly: On the decision of OPEC to reintroduce production quotas and reduce oil production, IfW-Box 2016.26, https://www.ifw-kiel.de/wirtschaftsppolitik/prognosezentrum/konjunkt/ifw-box/resolveUid/968f51a1d348565df0a0295a726df30c (9.1.2017 ).