Do high oil prices presage inflation? The evidence from G-5 countries

Business Economics, April, 2004 by Michael LeBlanc, Menzie D. Chinn

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.

**********

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.