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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.”

[snip]
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

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Comment Preferences

  •  Yep. (4+ / 0-)
    Recommended by:
    wu ming, techno, mightymouse, notdarkyet

    In the medium term, you can do a lot about resource dependence. In the long term, you can substitute away completely. In the short term, you're SOL.

    That said, there are two things which make me sort of hopeful. Firstly, core inflation is still low. In the '70s, oil price spikes translated directly into core inflation, so I hope the economy has become a bit more resilient, except for transportation.

    Secondly, while the US uses about twice as much oil per person to achieve a comparable standard of living as Western European states, that might also mean you have a lot of low-hanging fruit to pick.

    Iuris praecepta sunt haec: Honeste vivere, alterum non laedere, suum cuique tribuere. - Ulpian, Digestae 1, 3

    by Dauphin on Wed Mar 02, 2011 at 02:07:50 PM PST

    •  Boy, I HOPE you are right about that (1+ / 0-)
      Recommended by:
      Dauphin

      low-hanging fruit.  But I fear that most of western Europe's huge energy per GDP advantage is FAR from low-hanging.  We are talking about building huge mass-transit networks, building well-designed super-insulated homes, and 30 years of concentrated efforts in efficiency and alternative energy generation.  

      If that is what you mean by "low-hanging" I absolutely agree with you.

      •  Thing is, when you need a (1+ / 0-)
        Recommended by:
        techno

        crash program, a lot can be done quickly, so I'm actually not that worried about transit infrastructure not being able to be built quickly. I'm more worried about the political part of the equation: Fear, stubbornness, and Republicans can be a toxic mix.

        Iuris praecepta sunt haec: Honeste vivere, alterum non laedere, suum cuique tribuere. - Ulpian, Digestae 1, 3

        by Dauphin on Wed Mar 02, 2011 at 02:20:10 PM PST

        [ Parent ]

      •  major difference between the US and Europe (1+ / 0-)
        Recommended by:
        Dauphin

        We (USA) are the 3rd largest producer of crude oil in the world.

        So we recycle E&P profit back into the country.

        "The way to see by faith is to shut the eye of reason." - Thomas Paine

        by shrike on Wed Mar 02, 2011 at 03:05:20 PM PST

        [ Parent ]

  •  Why the oil shortage is a hoax (0+ / 0-)

    730  million barrel  in the US strategist reserve  http://spr.doe.gov/...  

  •  interesting diary (1+ / 0-)
    Recommended by:
    techno

    thanks for posting.

    I would say oil is kind of an addiction, at least here in the US. We have built our country's residential pattern based on the ability to drive long distances. It didn't have to be that way. We could have had a different specification. But we went down the road of oil-fueled growth and excessive consumption, which gave us some good economic highs while the price was low (lots of big houses in the suburbs means jobs in construction and marketing household products).

    And we need cheap oil to live like we do, or we will be in pain, like an addict. Paying through the nose to get to work will be tough.

    Hard to believe we didn't learn a blessed thing from the seventies oil shocks.

    An ambulance can only go so fast - Neil Young

    by mightymouse on Wed Mar 02, 2011 at 02:23:29 PM PST

  •  Your oil that you have paid for (0+ / 0-)

    730 million barrel ready to loaded and process   , Only thing Obama has too say is open the tap and it will flow freely , http://www.spr.doe.gov/...

    •  and when it's gone.... (0+ / 0-)

      The West would burn through the entire strategic reserve in a few months (or less). Then what? What happens if Saudi arabia implodes two years from now? The whole point of a reserve is that you have it for genuine emergencies (I lived through 1973..it wasn't fun), not for trying to combat the inexorable rise of oil prices over the medium and long run, nor short term glitches.

      •  Actually Both Bush's and Clinton (0+ / 0-)

        released some oil to lower prices.

        How about enforcing the speed limit to reduce consumption?

        Oh, look.....I get a tagline. I better not waste it. I'd rather have a bottle in front of me than a frontal lobotomy.

        by sd4david on Wed Mar 02, 2011 at 06:14:13 PM PST

        [ Parent ]

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