What is the relationship between oil prices and inflation?

Answer:

The price of oil and inflation are often seen as connected in a causal relationship. As oil prices move up or down, inflation goes in the same direction. The reason why this happens is that oil is an important contribution to the economy – is used for critical activities such as fueling transportation and heating homes, and if costs rise, so the cost of the final product. For example, if the price of oil rises, it will cost more to make plastic, and plastics companies will pass on some or all of these costs to consumers, raises prices and thus inflation.

A direct link between oil and inflation was evident in the 1970s when the price of oil rose from a nominal price of $3 before the oil crisis of 1973 to about $40 during the oil crisis of 1979. This helped cause the consumer price index (CPI) – a key measure of inflation, more than doubled to 86.30 by the end of the 1980s from 41.20 in early 1972. To put this in perspective, while it was previously 24 years (1947-1971) for the CPI twice, it took about eight years during the 1970-ies.

However, this relationship between oil and inflation started to deteriorate after the 1980s. In the 1990-ies the oil crisis, the Gulf war, oil prices doubled in six months around $40 from$ 20, but inflation remained relatively stable, growing to 137.9 in December 1991 from 134.6 in January 1991. This detachment in the relationship was even more obvious during the run-up in oil prices from 1999 to 2005, when the annual average nominal price of oil rose to $50.04 $16.56. In the same period the consumer price index rose to 196.80 in December 2005 from 164.30 in January 1999. Using these data, it turns out that the strong correlation between oil prices and inflation that was seen in the 1970-ies considerably weakened.

For more information, see our tutorial All about inflation and the consumer price index: a friend to investors.

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