Oil price shocks appear to have only transitory effects on headline inflation and virtually no impact on measures of underlying trend inflation.Petroleum products - Prices ; Inflation (Finance)

Mingyu Chen

Yi Wen

English

Research Papers in Economics

Economic SYNOPSES
short essays and reports on the economic issues of the day
2011 ■ Number 19
T
he significant rise in the world price of oil since the
end of the recession has renewed fears of consumer
price inflation. Because oil is used as a direct input for
many consumer items, it seems reasonable to assume that
higher oil prices will ultimately lead to higher prices for at
least some goods and services. These include gasoline, airfare,
and utility bills and may also include consumer items, such
as food and clothing, since energy is used as an indirect input
in just about everything. 
Economists call the effect that oil price shocks have on
inflation a “pass-through” effect. Evidence of a pass-through
effect appears strong during the oil price shocks in the 1970s
but seems to have disappeared since the mid-1980s. In fact,
empirical research consistently shows that oil price shocks
have not significantly affected the general prices of consump-
tion goods—except energy prices—since the mid-1980s. 
What this suggests is that if we examine the behavior of
“core inflation”—a measure of inflation that ignores food and
energy prices—we should find little or no evidence of a sig-
nificant pass-through effect.1 Indeed, this is what Evans and
Fisher (2011) find.2 These authors use an econometric model
to estimate the impact of oil price changes on core personal
consumption expenditures inflation. They find that between
1982 and 2008, core personal consumption expenditures infla-
tion did not respond to oil price shocks, although there is
evidence of a significant response prior to 1980. To examine
the pass-through effect, we use a similar methodology but a
different price index—the consumer price index (CPI). 
Using data for the period 1985-2011, we find that oil price
shocks have had little effect on core CPI, consistent with the
findings of Evans and Fisher (2011). We find significant effects,
however, on CPI inflation—the so-called “headline” inflation
rate. 
Specifically, we estimate that a $1/barrel permanent increase
in crude oil has virtually no effect on core CPI but causes a
0.03 percent (one-time) increase in the monthly CPI. So, for
example, a permanent $50/barrel increase in the world price
of crude oil is estimated to increase headline inflation by 1.5
percent. Moreover, the effect is estimated to be very transitory.3
Our results suggest that oil prices primarily affect energy
prices but not the prices of other components in the CPI.
Indeed, our estimation shows that a $1/barrel permanent
increase in crude oil can cause an immediate $0.03/gallon
permanent increase in gasoline. It is not fully understood,
however, why energy prices no longer pass-through to other
consumer goods and services as they once did. One possible
explanation is that the share of oil (or energy in general) in
total production costs has declined significantly since the first
two oil shocks in the 1970s, owing to the adoption of energy-
saving technologies. 
Therefore, oil price shocks appear to have only transitory
effects on headline inflation and virtually no impact on meas-
ures of underlying trend inflation. These empirical findings
provide some support for the use of core inflation (or some
other measure of trend inflation) over headline inflation for
the purpose of guiding monetary policy. ■
1 Economists sometimes like to use core inflation as a measure of trend inflation.
Food and energy prices are typically very volatile, so their short-run changes are
not necessarily good indicators of trend inflation, which is of most concern to
monetary policymakers.
2 Evans, Charles L. and Fisher, Jonas D.M. “What Are the Implications of Rising
Commodity Prices for Inflation and Monetary Policy?” Federal Reserve Bank of
Chicago Chicago Fed Letter, No. 286, May 2011;
www.chicagofed.org/digital_assets/publications/chicago_fed_letter/2011/cflmay2
011_286.pdf.
3 Although the effect on inflation is transitory, the effect on the price level is not,
because inflation is defined as the rate of change in the price level, not the price
level itself.
Oil Price Shocks and Inflation Risk
Mingyu Chen, Research Analyst
Yi Wen, Assistant Vice President and Economist
Oil price shocks appear to have only
transitory effects on headline inflation
and virtually no impact on measures 
of underlying trend inflation.
research.stlouisfed.org
Posted on July 6, 2011
Views expressed do not necessarily reflect official positions of the Federal Reserve System.

Oil price shocks and inflation risk

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Oil price shocks and inflation risk

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