Crude oil prices have risen recently, yet the impact may be muted: Higher prices won’t be a big drag on consumption, nor will they be sufficient to change the Federal Reserve inflation goals or alter expectations of three rate hikes this year.
If oil prices are rising because of a shock from low supply, it is considered a negative. If they are climbing because of stronger demand, it is not as problematic. A bit of both factors appears to be at work now. Global growth has picked up, led by strong activity in the industrial sector. Meanwhile, supply conditions have reached a better balance.
Former Fed Chair Ben Bernanke and the University of California economics professor James Hamilton have done useful work relating copper prices, 10-year Treasury yields and the dollar to an estimate of crude oil prices. The idea is that copper, yields and the dollar are all moving for the same reason: demand. Whatever is remaining is assumed to be a supply factor. We estimate that since the lows in June, about 60 percent of the increase in crude oil prices is supply-driven while the rest is attributable to strong demand. After all, copper prices and yields have both climbed in recent months. So the rise in crude prices looks fairly innocuous.
If recent experience is any guide, the movement in oil prices will translate fairly quickly into business investment. Crude prices lead investment in mining structures by about two to three quarters. At the same time, whatever hit there is to consumption looks pretty drawn out. Rising oil prices are said to have nonlinear effects. A gradual increase in prices has a modest impact on consumption. However, at some point, prices hit a level that prompts a more aggressive consumer reaction. In short, we see the rise in oil prices as a tailwind to growth over the next few quarters.
Because oil is a significant input for many companies, the recent upturn in crude prices has fueled speculation of pass-through to core consumer prices. That’s notable given the persistence of low core inflation rates in the U.S. However, in practice, the pass-through effect is quite limited. Thus, the rise in crude prices is unlikely to speed up the Fed’s exit.
Crude oil prices have been rising for two years. During that period, underlying consumer price inflation remained low. After bottoming in early 2016, Brent crude oil prices rose about 50 percent that year. Brent crude prices jumped roughly 20 percent in 2017. Yet, at 1.7 percent, the trimmed-mean PCE inflation rate was unchanged over this two-year period. Oil price pass-through to consumer prices has been falling over time. For example, from 1960 to 1985 the correlation coefficient between PCE ex-energy inflation and PCE energy was 0.70. In the years since, the correlation has dropped to 0.11. This is not especially surprising given the declining energy intensity of the U.S. economy.
One way to analyze the scope of energy price pass-through into core consumer prices is through an impulse response test. We follow an approach similar to the one outlined in a recent Fed paper. 1 This allows us to examine the response of an unexpected acceleration in oil prices to underlying consumer prices. The results showed that an unexpected 10 percent increase in the real oil price lifts core PCE inflation by 0.1 percentage point about six months after the shock, a small amount.
The impact is persistent, however, lasting for several years. Thus, the recent upturn in oil prices should be taken in context. Core consumer prices are still being affected by oil price declines from mid-2014 to early 2016. Because we were able to determine the pass-through from oil to core inflation, we estimate that the decline in oil prices between July 2014 and February 2016 reduced three-tenths of a percentage point from core PCE price inflation in 2015, and a third of a percentage point in 2016. The drag from oil prices will persist in 2018; it will disappear by 2023.
So the rise in crude oil prices is unlikely to have any meaningful negative impacts and is even likely to support a continued rebound in investment spending and have limited pass-through into core consumer prices.
Our analysis does not mean that inflation is unlikely to rise; rather, the pick-up in underlying consumer inflation will probably be modest. That’s one reason to be skeptical of a big drag on consumption. Moreover, the rise in oil prices is not enough to pressure the Fed’s inflation goals. Thus, we would resist the temptation that the Fed is likely to speed up the pace of hikes in the coming year.