Oil prices and inflation

Inflation is the process whereby ‘things’ – balloons, tyres, opinions, etc. – wbecome enlarged. Deflation is the reverse process. In economics, inflation generally refers to money; or to money prices. Deflation, however, more often refers to falling output; that is, to a decline in productive activity, usually accompanied by a rise in unemployment. By these definitions inflation and deflation are likely to occur simultaneously.

Prices rise in consequence of spending triggered by new money; but if money wages and salaries remain unchanged (or rise by a lesser amount), real incomes fall. Although this might look like deflation, those features may be part of a lagged readjustment, with wages and salaries eventually catching up with prices (an inflationary ‘price-wage spiral’).

Careful exposition and precise terminology is always desirable. Confusion would be lessened if (monetary) inflation were defined ascurrency debasement. By that definition, rising prices might be indicative of inflation; but not always. The (obvious) exception is when prices (or, more to the point, price indexes) rise for reasons other than currency debasement. Recent commentary on the ‘Arab spring’ illustrates the potential for confusion:

‘Traders argue that if another domino falls, and many mention the Opec member Algeria, then the oil price would immediately leap dramatically. Global inflation … would surge again. Living standards in Britain … would take another punishing hit.’ (Sam Fleming, The Times, 5th March)

While a surging oil price would cause most, if not all, published price indices to rise, the impact (on output and employment) would be deflationary. Yet, as rising oil prices raise the cost of commodities for which oil is a necessary input, incentives are created for producers to economise in the use of oil, and for consumers to switch their spending away from the most heavily oil-based commodities. Although these must check both the demand for oil and the rise in prices, it is nevertheless likely that the purchasing power of money would fall. Yet, the fundamental cause would not have been currency debasement.

In such circumstances it would be inappropriate for the authorities to attempt to forestall market readjustments, either by easing credit or by greater deficit spending. As the current ‘oil shock’ incites calls for ‘politicians and central bankers’ to ‘make monetary policy even more stimulative to sustain growth and employment’ (Anatole Kaletsky, The Times, 9th March 2011), it might be noted that this strategy was engaged to offset the deflationary impact of the oil price rise of 1973; and that it led to inflationpeaking at over 24% in the UK in 1975.

2 thoughts on “Oil prices and inflation”

  1. Posted 14/03/2011 at 14:06 | Permalink

    Together with the late Alan Walters, Brian Griffiths and others, I was one of the signatories to a brief ‘Memorial to the Prime Minister’ (Edward Heath) in 1973. We then said ‘There can be no lessening in the rate of inflation unless the rate of increase of the money supply is diminished.’ I find it disappointing, to put it no more strongly, that the Governor of the Bank of England, and so many members of the Monetary Policy Committee, seem to be complacent about the current rate of inflation — around 5 per cent a year, as measured by the Retail Prices Index. This is roughly the average annual inflation rate since the end of the Second World War, and it has resulted in the pound losing about 98 per cent of its purchasing power during my lifetime. That is a disgraceful record. I had hoped that the disease of currency debasement had been brought under control since the early 1990s, but it now seems the authorities are in serious danger of losing control again. May I suggest that the Governor of the Bank of England’s own pension should not be index-linked against inflation. That might encourage him to try harder to maintain the value of our money.

  2. Posted 02/04/2011 at 12:02 | Permalink

    We do not want the Governor to try too hard to maintain the value of our currency.It would almost certainly reduce national welfare. Any fool can quickly bring inflation back to target by, say, raising interest rates to 12% tomorrow. However that would have disastrous impacts on the variance of output and possibly its long run value. The current forecasts of The Bank of England suggest inflation as measured by CPI will be around target in two years time without any rise in interest rates and around target with small increases, the latter with a smaller band of uncertainty. The Bank of England has almost certainly not lost control of inflation and those trying to push it into premature interest rate increases ought really to join the inflation nutters club.

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