Oil Prices & Inflation: Understanding the Connection

Oil prices and levels of inflation are often seen as being connected in a cause-and-effect relationship. As oil prices move up, inflation—which is the measure of general price trends throughout the economy—follows in the same direction higher. On the other hand, as the price of oil falls, inflationary pressures start to ease. History shows that the two are indeed correlated, but the relationship has deteriorated since the oil spike of the 1970s.

In the spring of 2020, oil prices collapsed amid the economic slowdown. OPEC and its allies agreed to historic production cuts to stabilize prices, but they dropped to 20-year lows.

Key Takeaways

• Oil prices can affect levels of inflation in an economy by increasing the cost of inputs.
• There was a strong correlation between inflation and oil prices during the 1970s.
• Since the 1980s, the relationship between oil and consumer prices has diminished.
• The Producer Price Index (PPI) has a greater correlation with crude oil compared to the Consumer Price Index (CPI).

Cause and Effect

Oil and inflation are linked because 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 creates 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 over $30 just after the 1979 oil crisis. This helped push 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.

Shifting Trends

The relationship between oil and inflation started to deteriorate after the 1980s, however. During the 1990s and the Gulf War oil crisis, crude oil prices doubled in six months to around $30 from $14, but CPI remained relatively stable, growing to 137.9 in Dec. 1991 from 134.6 in Jan. 1991.

This detachment in the relationship between inflation and oil 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 from $16.50. During this same period, the CPI rose to 196.80 in Dec. 2005 from 164.30 in Jan. 1999. Using this data, it appears that the strong correlation between oil prices and inflation that was seen in the 1970s had weakened significantly.

CPI vs. PPI

There appears to be a greater link between oil and the Producer Price Index (PPI), which measures the price of goods at the wholesale level. Specifically, the correlation between oil prices and the PPI between 1970 and 2017 was 0.71, according to the Federal Reserve Bank of St. Louis.

The correlation between PPI and oil has been much stronger than with the CPI, which was 0.27 over the same period. "The weaker link between oil prices and consumer prices likely comes from the relatively higher weight of services in the U.S. consumption basket, which you’d expect to rely less on oil as a production input," according to the St. Louis Fed.