Relationship between Oil Prices and Inflation

Economists in the past 20 years have examined the relationship between oil prices and inflation. The common finding has been one of “limited” or “modest” correlation between these two variables. Michele Cavallo wrote on this topic in the FRBSF Economic Letter and made the observation that in the “1970s and early 1980s, rising oil prices were accompanied by double-digit overall inflation in the U.S. and in several other developed economies.” There were studies conducted using data from 1960-2000 and the results were ambiguous as they showed a strong relationship between oil prices and inflation only before 1981.

But since 2000 more economists have taken a look at this relationship through empirical studies of US, Japan, Canada, and Europe. Michael LeBlanc, economist of the US Department of Agriculture, collected data of recent oil prices and inflation rates in the US and Europe. He found “oil price increases of as much as 10 percentage points will lead to direct inflationary increases of about 0.1-0.8 percentage points in the U.S. and the E.U.” LeBlanc labeled the relationship as “modest” which is similar to the results found by José De Gregorio, Oscar Landerretche, and Christopher Neilson 3 years later.

The theme among these studies are that oil prices and inflation have an ambiguous relationship that can be hard to pinpoint. The question is whether oil prices directly impact prices of non-energy goods and services. Cavallo claimed in his article that a rise in oil prices, “when the central bank is credible… when inflation expectations are well-anchored… will not result in persistently higher overall inflation.” But it can be difficult to assert this claim as different periods of time see different fluctuations of oil prices and economic activity. What happens if one were to look at oil prices and inflation rates in the last year? or in the next few years?

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