Currency Thoughts

Crude Oil Prices and U.S. CPI Inflation

February 23, 2011

Oil prices were volatile but ultimately trendless through the latter 1980s and the 1990s.  West Texas Intermediate (WTI) prices averaged $19.37 from 1987 through 1998.  Broken down into three-year sub-periods, the overage price of oil was $18.26 per barrel in in 1987-89, $22.18 in 1990-92, $18.03 in 1993-95 and $19.01 in 1996-98.  There are 42 gallons in a barrel. 

Oil prices remained volatile but no longer trendless  after 1998, climbing to $25.10 in 1999-01, $32.82 in 2002-04, $65.18 in 2005-07, and $80.92 in 2008-10.  The price of WTI ranged from $50.49 to $98.18 in 2007, $32.40 to $147.27 in 2008, $33.98 to $81.37 in 2009, and between $66.88 and $92.21 last year.  The lowest daily closing of 2011 was set just eight days ago at $84.32 on February 15, yet today saw the market touch $97.98, highest since early October 2008.  The average price in 2005-2010 of $73.05 was 163% above the mean in 1999-2004, and the average price thus far in 2011 of $89.03 per barrel is already 22% above the mean in 2005-2010.

Neither total nor core U.S. CPI inflation have correlated well with the trend rise in oil prices.  Total consumer prices rose 3.3% per annum between end-1986 and end-1998, when oil prices were averaging $19.37 and exhibiting no cumulating long-term movement.  Core CPI, excluding food and energy, averaged 3.5% per annum in that period.  During the ensuing six years to end-2004, total and core inflation slowed to 2.5% and 2.1% per annum, respectively, and in the following six years to 2010, there was further deceleration to 2.4% and 1.9%.  Even those impressive reductions do not fully capture the extent of price deceleration.  In the year to January 2011, headline consumer prices rose 1.6%, and core went up 1.0%.

Critics of the Fed’s focus on core inflation sarcastically argue that such a framework might be fine for those humans who do not eat or travel.  That ridicule misses the Fed’s point as designed initially.  The exclusion of food and energy wasn’t made because those items are unimportant in a typical person’s spending menu.  Commodity prices are volatile and responsive to global, rather than national, economic forces.  Raising interest rates isn’t going to curb food or energy prices.  Moreover, the history in the final part of the 20th century suggested that episodes of rising commodity costs are self-correcting and eventually reverse themselves.  After more than a decade without trendless oil prices, that key assumption no longer seems valid, but Fed officials have another argument to throw back at their critics.  The period of upwardly trending energy prices has coincided with falling core inflation, and the drop in core has outweighed the rise in commodity costs, leading to very low and indeed lower-than-desired overall inflation.  Actual U.S. inflation has failed to meet the predictions of the Fed’s opponents.

Moreover, Fed officials tend to perceive a rapid rise in energy costs as disinflationary because of the likely dampening of economic growth.  The first OPEC shock in 1973-4 was associated with a recession.  So was the second OPEC shock, triggered by the Iranian revolution.  Saddam Hussein’s invasion of Kuwait in 1990 also was linked to a recession in the United States, and the surge of oil prices in the first half of 2008, although not the principal catalyst, no doubt made the recent Great Recession more severe than it otherwise would have been.

Alas, all those points do not constitute an entirely satisfying retort, because there is more to this story.  For one thing, in other economies like Britain, Euroland, and many emerging markets, commodity pressures are pushing overall inflation upward and above a pace widely agreed to represent price stability.  Why shouldn’t the United States follow a similar scenario eventually?  An inflation problem may be just a matter of time.  Because  changes in monetary policy affect growth and prices with long and variable lags, monetary authorities cannot afford to treat their task like the Bunker Hill patriots, not acting until the “whites” of the eyes of inflation are clearly visible.  A second point involves the role of inflation expectations in determining future inflation.  At the ECB, the anchoring of expected inflation has become the fundamental principle of monetary policy.  Given the frequency of energy purchases for consumers and businesses, sustained spikes in oil costs can exert disproportionate effects on the perception of current inflation and the expectation of future inflation. 

That’s how many other central banks are interpreting the current landscape, and the contrast between their attitude and the Fed’s has been a weight on the dollar.  Normally, one would expect the U.S. currency to be getting much more mileage than observed thus far from Middle Eastern unrest and a flight to safety. 

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

Tags: oil prices, U.S. consumer prices

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