crossposted from Real Economics
This question is incredibly important. The easy answer is the of course, higher oil prices will trigger inflation. How could this not be true? Oil prices are built into almost everything we see and touch in our industrialized country so if oil goes up, why wouldn't the price of everything go up?
Well, we can only hope that everyone doesn't buy this simple explanation because if that happens, some central banker will raise interest rates--count on it.
We can also hope that folks think deeper about this issue because the answer is FAR more nuanced and complex. Follow me below the fold.
Nothing. NOTHING! disrupts the global economy faster than rising oil prices. The reason is simple--oil (in its many refined manifestations) is the specified fuel for a host of critical applications. This isn't an "addiction" (with all the BS that word inspires) this is an industrial specification. Turn off the oil and the global economy grinds to a halt. Without a massive rebuilding of the oil-fueled infrastructure so it could run on some other energy source, there is literally no escaping the need for oil.
Therefore, when the price of this precious substance goes up, folks have no choice but to pay the bill. And because oil figures into such a wide assortment of market goods like food, everyone who can raise their prices to cover their oil bills will do so. In this way, raising oil prices will automatically raise the prices of almost everything else. When prices for everything goes up, economic commentators start screaming about "inflation."
And they would be right except for one thing--inflation cannot break out unless there is a mechanism to raise incomes to cover the higher prices. If incomes do not rise, higher oil prices will inevitably mean that folks will simply buy less of something else. Higher energy bills are deflationary because they crush demand. And when demand shrinks, the folks who want to raise prices to cover their fuel costs cannot do so. Enterprises start eating losses which if done over a long enough period of time, will put them out of business. And failing businesses really ARE deflationary.
So the answer to whether higher oil prices are inflationary or deflationary, the answer is obviously BOTH. In fact, in the 1970s we called this problem "stagflation" although the mechanisms for stagflation were usually misunderstood by Predator Class economists of both left and right.
Some other thoughts:
A Simple Rule Of Thumb Regarding Oil And How It Impacts The Economy
From Deutsche Bank, this is useful:
According to our analysis, a $10 increase in oil prices translates into roughly a 25 cent increase in retail gasoline prices. Every one penny increase in gasoline is then worth about $1 billion in household energy consumption. (In decimal terms, it is actually $1.4 billion.) Therefore, a sustained $10 increase in oil prices translates into $25 billion in additional household energy spending. Assuming this price rise crowds out spending elsewhere in the economy, effectively acting as a tax, means that a sustained $10 rise in oil prices reduces annual real GDP growth by 0.2% more
Why Higher Oil Prices Are Deflationary, Not Inflationary
Cullen Roche, Pragmatic Capitalism | Feb. 27, 2011,
There’s been a lot of good commentary in the last 24 hours regarding the deflationary impact of higher oil prices. Much of this discussion has been based around its impacts in Japan, however, it is applicable to the USA as well. In a piece this morning FT Alphaville commentary from Macquarie and JP Morgan regarding this effect:
As Macquarie Securities noted:
“We disagree with the view that deflation means Japan is the one country to benefit from higher oil prices. In the previous commodity boom, profits peaked in 1Q07 and domestic demand in 2Q07 as higher commodity prices pushed the economy towards recession well before the Lehman’s collapse.”
That’s right. For a nation suffering a balance sheet recession the likelihood is that higher oil costs will serve only as a tax. This supply shock results in depressing aggregate demand and furthering the likelihood of deflationary pressures. Paul Krugman elaborated on this:
“So, does a rise in food and energy prices do anything to alleviate these (deflationary) problems? No. In fact, it makes them worse, by reducing purchasing power. So while the commodity surge may temporarily lead to rising headline prices in Japan, the underlying deflation problem won’t be affected at all.”
That’s exactly right. At the end of the day rising oil prices will only crunch consumer balance sheets further which increases the likelihood of recession. more