Historical oil and gas prices

We estimate the effects of oil price changes on inflation for the United States, United Kingdom, France, Germany, and Japan using an augmented Phillips curve framework. We supplement the traditional Phillips curve approach taking into account the growing body of evidence suggesting that oil prices may have asymmetric and nonlinear effects on output and that structural instabilities may exist in those relationships. Our statistical estimates suggest current oil price increases are likely to have only a modest effect on inflation in the United States, Japan, and Europe. 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 United States and the European Union. Inflation in Europe, traditionally thought to be more sensitive to oil prices than in the United States, is unlikely to show any significant difference in sensitivity from that in the United States and in fact may be less in some countries.

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Movements in oil prices have complicated the tasks of policymakers and business leaders over the past three decades. Increases in inflation during the 1970s have been blamed, in part, upon rapid increases in petroleum prices. The long decline in inflation during the 1980s and 1990s has, in turn, been associated with declines in oil prices. Hence, a clear understanding of the strength of the empirical linkage between oil price changes and inflation is key to the proper conduct of monetary policy. To the extent that firms must alter their pricing policies according to the inflationary environment, firm managers also need to perceive the links accurately.

While most of the examples that come to mind are historical in nature, it would be a mistake to conclude that the impact of oil prices on the macroeconomy is now unimportant. For instance, in September 2000, crude oil prices in the United States reached $37 per barrel, more than tripling from levels in December 1998. Similarly, average world oil prices increased from $9 per barrel to $33 per barrel. And while the oil market responded with additional production, oil prices remained high and volatile until the spring of 2001. As oil prices increased, so did concerns about increasing inflation both in the United States and abroad. Beginning in June 1999 through May 2000, the Federal Open Market Committee of the Federal Reserve Board, partly in response to increasing oil prices, increased the federal funds rate on six different occasions. In other countries, rising oil prices complicated central bankers' efforts to check inflation and moderate changes in exchange rates, a particular concern in Europe.

Even more recently, energy prices again took on a central role in 2003, as oil prices again breached the $33 mark as international tensions increased in the run-up to the Iraq conflict. While prices fell substantially in the wake of combat operations, by January 2004, they had again risen to the comparable levels.

This study examines two related questions. First, what is the effect of increasing oil prices on inflation? Second, does the inflationary effect vary across countries? We answer these questions by exploring the effect of oil prices on inflation in the United States and other industrialized countries, including the record-setting spike in oil prices in 2000 (larger than the 1973, 1979, and 1990 shocks in nominal terms). Our work also bears on the question of how much credit falling oil prices deserve for the relatively low levels of price inflation throughout the 1990s. (1)

We estimate the effects of oil price changes on inflation for the United States, United Kingdom, France, Germany, and Japan using an augmented Phillips curve framework. Because oil prices are a component of our Phillips curve model, answers to these questions can be read directly from parameter estimates. We supplement the traditional Phillips curve approach taking into account the growing body of evidence suggesting (1) that oil prices may have asymmetric and nonlinear effects on output and (2) that structural instabilities may exist in those relationships. Davis and Haltiwanger (2001), for example, view the evidence for asymmetric responses to oil price ups and downs as well established. Others have argued (Lee, Ni, and Ratti, 1995 and Hamilton, 1996a, 1999) that large or surprising oil price shocks have proportionally larger effects. Not surprisingly, Hooker (1999) finds that many of these statistical results are sensitive to model specification and sample period considered.

In deference to the controversy over a structural-break in the oil price/inflation relationship, we focus our estimation on the period 1980Q1 to 2001Q4. (2) We find that the abrupt oil price increases experienced in the late 1990s had only modest inflationary effects, although differences in the size of the effects exist across the United States, Japan, and Europe. The econometric evidence for this result is fairly robust to different specifications of the Phillips Curve relationship, oil price shocks, and lag lengths.

Inflation in the 1990s

The average inflation rate in the United States during the 1990s was unexceptional--inflation was lower in the 1950s and 1960s. (There was, however, less inflation in the 1990s than there was in the 1980s and especially the 1970s.) The 1990s look more distinctive once we look at the variability of inflation. As measured by its standard deviation, inflation was only one-third as volatile during the 1990s as it was during the 1980s. It was 24 percent less volatile during the 1990s than during the 1960s, the second-best decade as ranked by inflation volatility. Inflation during the 1990s was perhaps more notable when viewed against the backdrop of prevailing economic conditions.

During the 1990s, price inflation in the United States and most industrialized countries was stable or even decelerating despite generally rising economic activity and tightening labor markets. One plausible explanation for the unexpectedly slow rise in prices relative to wages was that economies benefited from favorable supply shocks from the energy sector throughout much of the decade (Figure 1).

The precipitous run-up of oil prices beginning in 2000 was preceded by an exceptionally weak oil market. Early in the fall of 1998 several elements combined to weaken oil demand and prices in the United States. They included a drop in the demand for heating fuel and lowered expectations of continued strong commitment to production cutbacks by OPEC producers. The world-wide rate of oil inventory accumulation averaged about one million barrels per day in 1998, completing a three-year run of storage builds totaling about 730 million barrels or well over nine days of supply. This increase in stock levels was a major force in keeping downward pressure on oil prices in the United States throughout 1999 (Figure 2).

Only one year later uncertainty, volatility, and inflexibility characterized the oil market. Industry stocks of crude and refined products were low during 2000, roughly in line with levels in 1996 when demand was six percent below 2000 levels. With so little margin to meet unexpected demand increases, the market was exposed to disruptions and the threat of regional supply imbalances. The benchmark one-month forward price of crude oil peaked at $37.80.

Oil prices continued to stay high throughout the fall, showing little or none of the anticipated declines expected to be generated by excess production over demand. The monthly U.S. imported crude oil price in November was a little over $31 per barrel (about $34 for West Texas Intermediate crude oil), in nominal terms the second highest monthly average level in the decade.

The Inflation Transmission Mechanism

Oil price spikes pose a difficult problem for central bankers. An increase in the price of oil, for instance, raises firms' costs and the prices they charge for their products. Holding non-energy prices constant, this tends to raise inflation and, for a given level of aggregate demand, pushes the economy toward recession. The central bank then has a choice between implementing a contraction-ary monetary policy to fight inflation and an expansionary policy to fight recession. In the face of supply shocks, the Fed cannot stabilize inflation and the real economy simultaneously.