A:

The price of oil and inflation are often seen as being connected in a cause and effect relationship. As oil prices move up or down, inflation follows in the same direction. The reason why this happens is that oil is a major input in the economy - it is used in critical activities such as fueling transportation and heating homes - and if input costs rise, so should the cost of end products. For example, if the price of oil rises, then it will cost more to make plastic, and a plastics company will then pass on some or all of this cost to the consumer, which raises prices and thus inflation.

The direct relationship between oil and inflation was evident in the 1970s, when the cost of oil rose from a nominal price of $3 before the 1973 oil crisis to around $40 during the 1979 oil crisis. This helped cause the consumer price index (CPI), a key measure of inflation, to more than double from 41.20 in early 1972 to 86.30 by the end of 1980. Let's put this into perspective: while it had previously taken 24 years (1947-1971) for the CPI to double, during the 1970s it took about eight years.

However, this relationship between oil and inflation started to deteriorate after the 1980s. During the 1990's Gulf War oil crisis, crude prices doubled in six months from around $20 to around $40, but CPI remained relatively stable, growing from 134.6 in January 1991 to 137.9 in December 1991. This detachment in the relationship was even more apparent during the oil price run-up from 1999 to 2005, in which the annual average nominal price of oil rose from $16.56 to $50.04. During this same period, the CPI rose from 164.30 in January 1999 to 196.80 in December 2005. Judging by this data, it appears that the strong correlation between oil prices and inflation that was seen in the 1970s has weakened significantly.

For more information, see our Inflation tutorial and The Consumer Price Index: A Friend To Investors.

RELATED FAQS
  1. How does the price of oil affect the stock market?

    Read about how the price of oil might impact the stock market and why economists have not been able to find a strong correlation ... Read Answer >>
  2. Why are stocks and oil so correlated right now?

    Learn whether the stock market and oil prices will continue their highly correlated price relationship or decouple again ... Read Answer >>
  3. If oil producers run out of room to store oil, will the price of gasoline plummet?

    Learn about what happens to gasoline price when room to store oil runs out and whether this creates a good situation for ... Read Answer >>
  4. How Can Inflation Be Good for the Economy?

    Find out why some economists and public policy makers believe that inflation is a good, or even necessary, phenomenon to ... Read Answer >>
Related Articles
  1. Investing

    How Oil Prices Impact the U.S. Economy

    Now that the United States has increased oil production through shale oil and fracking, low oil prices can harm the U.S. oil industry and its workers.
  2. Investing

    The Strategic Oil Reserves Explained

    Strategic oil reserves are one of the least known and least understood national security measures in the United States.
  3. Investing

    Oil Boom 2.0: Be Sure You Are Ready to Invest

    Learn about the potential for oil boom 2.0, and discover why some experts say this is a good time to invest in oil companies and ETFs.
  4. Investing

    Who is Most Affected by Lower Oil Prices?

    With low oil prices affecting just about everyone, from citizens to corporations to entire nations, we look at who wins and who loses with the price drop.
  5. Investing

    How Does Crude Oil Affect Gas Prices?

    Find out how this commodity's fluctuating price affects more than just how much you pay at the pump.
  6. Financial Advisor

    Is Now the Right Time to Buy Oil Stocks?

    Learn about the oil industry and how crude oil effects the prices of oil stock. Understand if now is a good time to purchase oil stock.
  7. Investing

    Peak Oil: What To Do When The Wells Run Dry

    Find out how to invest and protect your investments in this slippery sector.
  8. Investing

    Take Advantage of Cheap Oil, Invest in these ETFs

    With crude oil prices at record lows, investors should consider oil ETFs over oil company stocks as ETFs more closely mirror the price of oil
  9. Investing

    Investing in Oil Stocks vs. Oil Companies: What's the Difference? (USO)

    Learn about the major advantages, disadvantages and risks of investing in oil companies and investing in oil and gas exploration companies.
  10. Investing

    What We Learned From The Last Oil Shock

    The last oil shock in the 1970s carries some valuable lessons for consumers facing a repeat today.
RELATED TERMS
  1. Inflation Trade

    A method of investing that seeks to profit from an overall increase ...
  2. Headline Inflation

    The raw inflation figure as reported through the Consumer Price ...
  3. Crude Oil

    Crude oil is a naturally occurring, unrefined petroleum product ...
  4. Oil ETF

    A category of exchange-traded funds that invest in companies ...
  5. Peak Oil

    A hypothetical date referring to the world's peak crude oil production, ...
  6. Inflation Protected

    The types of investments that provide protection against inflation ...
Hot Definitions
  1. Contango

    A situation where the futures price of a commodity is above the expected future spot price. Contango refers to a situation ...
  2. Stop-Loss Order

    An order placed with a broker to sell a security when it reaches a certain price. A stop-loss order is designed to limit ...
  3. Acid-Test Ratio

    A stringent indicator that indicates whether a firm has sufficient short-term assets to cover its immediate liabilities. ...
  4. Floating Exchange Rate

    A country's exchange rate regime where its currency is set by the foreign-exchange market through supply and demand for that ...
  5. Taxes

    An involuntary fee levied on corporations or individuals that is enforced by a level of government in order to finance government ...
  6. Impaired Asset

    A company's asset that is worth less on the market than the value listed on the company's balance sheet. This will result ...
Trading Center