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Peter Taberner

Peter Taberner

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Does A Link Remain Between Inflation And Oil Prices?


Many economists would argue that there is a complex relationship between oil prices and inflation, comprising of many differing factors.

There seems to have been a calming of that connection since the peak of the oil crises in the seventies, which saw rocketing oil prices noticeably hiked inflation, but some patterns still remain and are envisaged between oil and consumer prices.

Midway through 2014, the cost of a barrel of crude oil began to fall, and a study last year by economist Alejandro Badel and research associate Joseph McGillicuddy for the Federal Reserve Bank of St Louis, revealed simulations of different paths of inflation.

If oil prices rebounded to $100 per barrel in the first half of this year, inflation would jump to 4.5 percent, and then fall to around 2 percent in June next year.

Alternatively, if the cost of oil remained static at the current spot price of $52 per barrel at the time of writing, then inflation would jump up to 3 percent in January this year, then be reduced back to the 2 percent mark by midway through next year.

Conversely, if prices were to fall to $20 per barrel, then the consumer price index would fall to a minus 1 percent level, eventually settling at 2 percent in June 2017.

All three scenarios point to a shock effect of oil price fluctuation, which eventually settles down into an even path.

The reality is that, through a year of volatile oil prices in the United States, there is some evidence of an effect on inflation rates.

Although, as oil prices were falling in the latter part of 2015, inflation in the United States alone was actually increasing.

In January, when oil prices reached a nadir of $28 per barrel, inflation slipped down to 1 percent in February from 1.4 percent in January.

As prices increased and steadied as the year progressed, there was only a 0.1 percent deviance from an inflation rate of 1 percent, between February and June.

Oil prices then began to slip again in July, and in early August fell down to $41.80 bbl, the lowest that oil had been since April.

Inflation slipped to 0.8 percent in July, and then oil prices rebounded in August as OPEC talks over a possible reduction in oil production became known. Oil moved up to just under $51 bbl in August, before inflation figures in September confirmed a hike of up to 1.5 percent.

In the United Kingdom, there was more evidence that the recent increase in oil prices had an effect on inflation, removing the windfall for motorists and consumers in general. Related: Is The U.S. Set To Become An LNG Powerhouse

Prices rose to 1 percent from 0.6 percent month on month in September, with the plummeting value of sterling since the decision to vote out of the European Union, another major reason for the inflation hike.

Inflation predictions are also a significant aspect of stock market speculations.

For example, there was as a fall in breakeven inflation rates, the difference between the nominal yield on a fixed-rate investment and the real yield, on an inflation-linked investment of similar maturity and credit quality, alluding to the United States $28 per barrel price back in January.

These are measured using the premium paid for Treasury inflation-protected securities, over standard Treasury bonds.

Over a longer period of time, oil prices may also have an effect on inflation swap rates, a derivative which transfers inflation risk, through an exchange of cash flows.

A study carried out by economists David Elliott, Chris Jackson, Marek Raczko and Matt Roberts-Sklar for the Bank of England, followed inflation swaps and the effect of daily oil spot prices.

In a regression model, constant and lagged inflation swap rates, were compared to current and changing oil spot prices, and calculated the effect of inflation expectations over three years and five years (5y5y).

The results from this model were from between January 2009 and July 2015.

Over the duration of three years of inflation swaps there was a significant effect, especially for the United States which jumped up to 1.2 basis points.

And the Euro area and the UK experienced a hike of just under 1 and 0.4 basis points respectively.

Over five years the influence of the model dissipates in the case of the UK, but it is still significant in the United States and the Euro area.

The study reads: “The regression results imply that, for example, a 10 percent fall in the oil price is associated with falls of approximately 4 basis points in U.S. 5y5y and 2 basis points in Euro area 5y5.”

John Corrigan, principal of StrategyX, Pricewaterhouse Cooper’s strategy consulting business, reflected: “Higher oil prices can drive inflation for consuming countries, and most OECD countries will calculate inflation with and without oil prices due to the volatility.”

“However, given the energy content of most goods and services, taking into account shipping, trucking, rail, etc, energy is a significant cost component in most products.”

He added: “Timing and magnitude of these impacts can vary depending on the relative state of the economy, and the ability of producers to pass along the cost increases.”

“In terms of inflation driving oil prices, these effects are more likely to be driven by what is causing the inflation - high GDP growth and high consumer demand. Both of which will drive demand for oil and thus oil prices.”

Corrigan went onto conclude that oil is a very global and liquid commodity, thus prices are driven by global conditions more than local conditions. Related: How Trump Can Help OPEC Reach Its Production Quota

However, currency issues come into play when talking about local market prices. Oil trades largely in USD, so any country, as in the currently the post-Brexit UK, whose currency loses relative value to the dollar will see costs per barrel go up.

This in turn is translated into inflation of all of the goods and services with significant oil energy cost components

He continued: “As a commodity and basic need for most economies, oil price increases are more likely to drive inflation than price increases in elective purchases like cars. The ability of people to increase or decrease consumption will impact the broader inflation impacts.”

“For instance, the impacts on today's economy is much less than it was in the 1970's due to greater energy efficiency in the economy. Thus, demands on personal income will be lower during price increases.”

By Peter Taberner for Oilprice.com

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