What is the relationship between oil prices and inflation?

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 to 86.30 by the end of 1980 from 41.20 in early 1972. To put this into greater perspective, while it had previously taken 24 years (1947-1971) for the CPI to double, it took about eight years during the 1970s.

However, this relationship between oil and inflation started to deteriorate after the 1980s. During the 1990's Gulf War oil crisis, crude oil prices doubled in six months to around $40 from $20, but CPI remained relatively stable, growing to 137.9 in December 1991 from 134.6 in January 1991. This detachment in the relationship was even more apparent during the oil price run-up from 1999 to 2005, when the annual average nominal price of oil rose to $50.04 from $16.56. During this same period, the CPI rose to 196.80 in December 2005 from 164.30 in January 1999. Using 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 tutorial All About Inflation and The Consumer Price Index: A Friend to Investors.