Oil Prices and Inflation
By Pierre Lemieux
Many if not most economists must find annoying the frequent media reports on the presumed relation between the price of oil and inflation. Or perhaps many have become unsensitized? Here are two examples chosen more or less at random—but from two serious financial newspapers. Last summer, The Economist wrote (“Worker Shortages Could Heal America’s Economy,” July 12, 2018):
Yet the economy has not yet overheated. Only recently has inflation hit or exceeded 2%, the Fed’s target, for three straight months—and that is partly because of a worldwide recovery in oil prices.
Just a few days ago, the Wall Street Journal wrote something to the same effect (“Cheaper Oil Ripples Through the Global Economy,” December 11, 2018), this time in the context of falling oil prices:
Now, with the recent tumble in oil, economists are waiting to see how the pullback in fuel costs will affect inflation.
So, we are told, increasing crude oil prices push inflation up and decreasing crude prices push inflation down (or prevent it from increasing). This just one instance of the widespread intuition that the change of a particular price adds to, or subtract from, inflation.
This is not correct, at least with a consistent and useful definition of inflation and price. If inflation is a general increase in the price level, it refers to a cause that pushes up all prices in terms of money, whatever their relative variation among themselves. If inflation increases all prices by 2%, the price of gasoline relative to other goods will not change. Inflation is not the effect of this or that rising price. The price of a specific good is a relative price—relative to money or to some other good. All prices are relative prices.
A more technical rendering of the same idea is the following: On the economy’s production possibility frontier (for a short explanation of the PPF, see my “Cheaper Oil Will Not Hurt the Economy,” Regulation, Spring 2015), a lower price of oil (in terms of other goods and services) means a higher price of other goods and services (in terms of oil). A lower price of oil means that, for a barrel of oil, you can get more of other goods and services. The change of one price cannot, per se, impact inflation.
The PPF relates to two basic ideas. First, when all resources are employed (given existing institutions and the incentives they create), producing more of something requires producing less of something else. Second, producing more of something involves increasing marginal cost as less productive resources are called upon. For example, as oil production increases, more and more labor specialized in house building must be diverted from that industry, increasing the cost of oil in terms of houses; the construction supervisor will end up being attracted to a roughneck job.
It is true that a shift in the PPF can cause a change in the general price level. The fracking revolution, for example, shifted the PPF up, and presumably reduced inflation compared to what it would otherwise have been as the same number of dollars started chasing more goods. Inversely, a reduction in oil production due to, say, depleting reserves would shift the PPF down and generate inflation—the same quantity of dollars chasing fewer goods. In such cases, we could speak of a temporary impact of oil on inflation. But the cause is not the change in one relative price; it is a change in the production possibilities of the whole economy.
One way to make sense of the claim that crude oil prices have an impact on inflation would be to argue that oil is an intermediate product used in the fabrication of many consumer goods (from gasoline to plastic widgets). In this perspective, an increase in the price of crude oil appears to increase inflation through the reduced supply of the many consumer goods using oil as an input. But appearances are deceiving. If, say, half the prices of consumer goods increase (in terms of the other half), it means that the other 50% of prices have decreased (in terms of the first half). So the price of crude oil has not increased the whole level of prices as inflation does; we have just moved along the economy’s PPF. Inflation (or deflation) must involve shifts in the PPF or changes in the quantity of money.
This approach is consistent with Milton Friedman’s theory that “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output” (emphasis in original; see his “The Counter-Revolution in Monetary Theory”). I think it’s difficult to argue otherwise.
Observation seems to confirm (or, more precisely, not to invalidate) the theoretical result that a change in oil prices does not impact inflation. The scatter diagram below shows annual changes in the average Consumer Price Index (CPI) against annual changes in the average price of the West Texas Intermediate benchmark oil. (Clicking on the diagram will bring you to the original FRED figure and data.) There is no obvious correlation.