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. In what manner will a recession likely affect the marginal-propensity-to-save rate ...

    Learn why recessions are often accompanied by an increase in the marginal propensity to save and whether this is a concerning ...
  2. What are key economic growth rates that can be used to determine the economic health ...

    Discover the indicators that correlate with real economic health, and learn why many traditional metrics do not function ...
  3. Why would a country's gross domestic product (GDP) and gross national income (GNI) ...

    Understand the economic metrics, gross domestic product, or GDP, and gross national income, or GNI, and why the two evaluations ...
  4. While closely related, how do gross domestic product (GDP) and gross national income ...

    Learn how gross national income is different from gross domestic product due to net foreign income received by a country's ...
RELATED TERMS
  1. Deflationary Spiral

    A deflationary spiral is when a period of decreasing prices (deflation) ...
  2. Nordic Model

    The social welfare and economic systems adopted by Nordic countries.
  3. Insurance Inflation Protection

    Insurance inflation protection is designed to allow policyholders ...
  4. Welfare Capitalism

    Definition of welfare capitalism.
  5. Benchmark Crude Oil

    Benchmark crude oil is crude oil that serves as a pricing reference, ...
  6. LIBOR

    LIBOR or ICE LIBOR (previously BBA LIBOR) is a benchmark rate ...

You May Also Like

Related Articles
  1. Economics

    10 Most Influential Chinese Companies

  2. Stock Analysis

    Is Now the Time to Bet on Vacation Spending?

  3. Economics

    Why Israel Is Attracting Chinese Investors

  4. Chart Advisor

    Commodity Traders are Watching These ...

  5. Economics

    Venezuela: Portrait of a Country in ...

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!