Higher Oil Prices Do Not Equal Higher Trend Inflation


Be sure to read the update.  An oil price shock will cause a one time increase in the price level, but not a sustained rate of change.

Caroline Baum goes after the confused thinking on oil prices and inflation:

It must be the noxious fumes or the stratospheric prices because crude oil crossing the $100 threshold makes normally thoughtful individuals funny in the head.

The early symptoms of high oil price syndrome, or HOPS, can easily be masked or confused with a more generalized form of lazy economic thinking.

For example, those afflicted with HOPS start making assertions that higher oil prices are inflationary, as if relative price changes can morph into an economy-wide rise in prices without help from the central bank.

One implication of this is that the Fed should not tighten monetary policy since the higher oil prices are just a relative price change.  The Fed should also not loosen monetary policy to ease the pain of such  relative price shocks.  As Baum notes, that is what the Fed did in the 1970s and look what it got us.  The Fed should only respond to aggregate demand shocks.  This piece dovetails nicely with Mark Thoma’s  post where he considers whether the Fed should respond to commodity prices in general.  
Update: I should have been more clear: a relative price shock can lead to a higher price level, but not higher trend inflation. There might be a one-time increase in the inflation rate, but not a permanent one from such shocks.  The post title has been adjusted accordingly.

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Higher Oil Prices Do Not Equal Higher Trend Inflation
david.beckworth@gmail.com (David Beckworth)
Fri, 11 Mar 2011 15:29:00 GMT

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