Rising Oil Prices Create Inflation?

With oil prices rising rapidly and the euro and the Australian dollar declining sharply (to name only two currencies to fall persistently), it appears that a rough road is ahead for the world’s economies. Perhaps the biggest concern for those countries which import oil is that a new wave of inflation will sweep over them. After all, isn’t it likely that inflationary pressures could force interest rates upward and cause a slowdown in economic growth?

These fears have been compounded by an International Monetary Fund (IMF) report in its “World Economic Outlook” announcing that rising oil prices might trigger inflationary pressure in most economies.

Once again, the IMF economists have got it wrong. Rising oil prices cannot be viewed as the primary cause of inflation: not now, not ever.

In the first place, most industrialized economies have a smaller weight assigned to oil and energy in the basket of consumer goods that are used to measure inflation—assuming for the moment that that really measures inflation. The diminished weight for energy reflects a declining importance of industrial production in those countries as they shift to services and information technology.

The overall picture for emerging market economies is slightly more complicated since most of their currencies have fallen against the dollar. Given that all contracts for oil products throughout the world are denominated in U.S. dollars, those countries are hit with a double whammy. Yet quite a few emerging market economies are benefiting from the price rises since they are net exporters of petroleum (for example, Indonesia, Malaysia, Mexico, and Venezuela). And then some emerging market economies have also decreased their dependency on oil imports. For example, Thailand’s oil purchases as a percent of total imports are down from 25 percent in the 1970s to about 8 percent.

The Real Problem: Central Banking

In all events, inflation is unlikely to be a problem in any country unless its central bank expands the rate of growth of the money supply to support levels of consumption seen before the upsurge in oil prices. If the banks abstain from increasing the money supply, consumers and producers will behave rationally and decrease their use of oil products to offset the higher prices.

The simple truth is that, by themselves, rising oil prices cannot cause inflation. Most people seem to have forgotten the hard-earned lesson that inflation occurs when too much new money or credit is pumped into the economy.

A more likely scenario is a slowdown in GDP growth, especially in the emerging market economies. Estimates for the effect of oil prices’ remaining at about $33 a barrel suggest that GDP growth in industrial economies would fall by one-quarter to one-half of a percentage point next year while the effect on emerging economies might be double.

This will be worsened if governments are tempted to provide subsidies to offset rising oil prices. In response to a protest by local farmers, Thailand’s government paid more than $25 million. Such politically motivated actions will only hide the costs and shift them to the long term.

Now, what to do about those currencies that have fallen so precipitously against the U.S. dollar? Unfortunately, governments cannot do much that will make matters better. What is worrying is that there will be some temptation to raise interest rates to prop up their currencies. This would only make things much worse.

In all events, the connection between foreign exchange (Forex) values and key economic variables is different from what it was in the past. Among these key variables were relative rates of inflation (lower inflation; stronger currency), relative rates of interest (higher interest rates; stronger currency), relative performance of the economy (higher growth; stronger currency), and expectations about the future (optimism about local economy’s performance; stronger currency). In the past, trade flows were perhaps the most important single determinant of Forex values.

But that was then. Now capital markets are increasingly efficient and remarkably global. More than a trillion dollars are traded each day, an amount more than ten times what is needed to pay for trade transactions. In the end, attempts by governments to manipulate their currencies using their foreign reserve balances or monetary policy will be less effective.

If countries with weak currencies wish to avoid inflation, they need not worry about rising oil prices per se. As Milton Friedman has said, “Inflation is everywhere and always a monetary phenomenon.” Governments and citizens would do well to remember this adage.