William R. Emmons

English

Research Papers in Economics

Inflation, Exchange
Rates, and Oil Prices
Crude oil is priced and traded in U.S. dollars.
However, most producers and users of refined oil prod-
ucts around the world earn and spend other currencies.
Furthermore, inflation occurs at different rates in dif-
ferent countries.  The theory of purchasing-power parity
(PPP) suggests that changes in exchange rates should
offset inflation differentials, at least in the long run,
keeping the “real” price of a common basket of goods and
services roughly comparable across countries.  Can we
use PPP to explain movements in the inflation-adjusted,
local-currency prices of crude oil?
The figure below compares inflation-adjusted, local-
currency oil prices in the United States, Japan, and
Germany during the last four decades.  Expressed in
terms of 1995 consumer prices, a barrel of oil cost
$15.39, Y5862, or DM39.79 in the first quarter of
1960.  A barrel of oil cost $27.87, Y3350, or DM63.80
in the third quarter of 2000, also expressed in 1995
prices.  For convenience, the figure shows indexes of
inflation-adjusted, local-currency oil prices that have
been rebased to equal 100 for each country in the first
quarter of 1960.
Inflation-adjusted, local-currency oil prices (exclud-
ing taxes) are much lower now in Japan than 40 years
ago, even after the sharp recent increase.  Of the three
major subperiods evident in the chart—the “pre-oil
shocks period” of 1960-1972, the "oil shocks period"
of 1973-1985 and the "post-oil shocks period" of
1986-2000—only during 1986-2000 were average real
oil prices lower in yen terms than they were in the
third quarter of 2000.  On the other hand, inflation-
adjusted oil prices in dollars and marks (or euros) are
relatively high now compared to previous periods.
Only during 1973-1985 were real oil prices higher in
the United States and Germany than they were in the
third quarter of 2000.
Clearly, forecasts of oil prices based on PPP using
consumer-price indexes and current exchange rates would
not have been very accurate in recent decades.  First, the
dollar price of oil changed erratically during the last 40
years compared to the prices of broad consumer baskets
of goods and services.  This is indicated by abrupt upward
and downward movements in the index levels in all three
countries.  Second, real exchange rates between the dollar,
yen and mark (euro) have also varied substantially.  This
is demonstrated by the divergent time paths of real oil
prices facing consumers in the three countries investi-
gated here.
The chart demonstrates that the recent inflation-
adjusted, local-currency oil-price shock has been
greatest in percentage terms in Germany among the
three countries considered here.  The real mark (or euro)
price of crude oil increased by 211 percent from the
fourth quarter of 1998 through the third quarter of 2000,
compared to 133 and 125 percent increases in real dollar
and real yen terms, respectively.  The much greater price
impact evident in Germany reflects the fact that the
mark (euro) has depreciated significantly against the
dollar and yen during the last two years.
—William R. Emmons
InternationalEconomicTrends
November 2000
Views expressed do not necessarily reflect official positions of the Federal Reserve System.
Inflation-Adjusted Local-Currency Oil Prices
10
100
1000
Q1.1960 Q1.1965 Q1.1970 Q1.1975 Q1.1980 Q1.1985 Q1.1990 Q1.1995 Q1.2000
USA Japan Germany
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Inflation, exchange rates, and oil prices

http://research.stlouisfed.org/publications/iet/20001101/cover.pdf

Inflation, exchange rates, and oil prices

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Research Papers in Economics