Inflation and Oil Price

Inflation was likely to pick up to between 4% and 5% in the near term, and to remain well above the 2% target throughout 2011, boosted by the increase in VAT, higher energy and import prices, and some rebuilding of companies’ margins. The projection for the first half of the forecast period was markedly higher than in November, due largely to the recent increases in the prices of commodities and other imported goods and services – according to the minutes from MPC meeting in Feb 9-10 2011

The statement from the MPC minutes and in the February Inflation Report provoked a review of the relationship between oil and general inflation. Previously, the relation between inflation and VAT was analysed. This post will examine the quote by from MPC minutes above.

Chart.1 Oil pushing up Consumer Price Index

Chart.1 shows the ebbs and flows between oil measured in sterling and the annual rate of inflation of UK consumer price index. It is evident the peaks and troughs in oils price precedes the peak and troughs of the inflation rate. The Middle East popular uprisings that began in December 2010resulted surge in oil price. Since December 17 2010, the beginning of Tunisian riots to March 14 2011, the price of oil has increased by 18%. During this period, mass demonstrations demanding devolution of power from politicians and royal families have occurred in Egypt, Bahrain, Morocco, and Libya. However, the Sterling Brent Oil Futures (as of March 14 2011), suggests that oil price may reach its apex; in May 2011. The BOE (MPC), in their deliberations over monetary policy will have to consider, whether oil price hikes are permanent or will prices will trend downward as calm returns to the region.

Furthermore, Chart.1 points out that the sharp run up in oil prices is not the sole driver behind the recent rise in the rate of inflation. The gap in growth of CPI all items and CPI excluding energy is marginal. This indicates other factors are causing inflation to rise.

Chart.2 UK Import Price and Oil Price

Chart.2 shows the relationship between the price of oil and UK import prices. Oil prices have led import prices since the oil price peak in mid-2008. Prior to this date, the relationship appears to be coincident.  The spread between growth in import prices all items and import price excluding energy was at widest at the turning points in oil price. This turning points being mid-2008 oil price peak and May 2009 trough in oil prices. Most recently, despite the surge in oil prices close to the mid 2008 peak the spread between imports price and import prices excluding has not widened significantly. Again this is due to other drivers of import prices, that are not energy related

Table.1 Correlations of Oil, Import Price and Inflation



 

 

 

 

 

Table.1 highlights the correlation coefficients between oil and the three measures of inflation. As anticipated, oil has as a stronger contemporaneous relationship with all the price measures.The intensity of correlation is strongest with CPI all items and correlation intensity is strongest when the price of oil is led by three months.

Chart.3 Inflation Energy and Commodities

*Oil and Commodity prices in converted to Sterling

Chart.3 depicts energy, commodities and inflation measures re-based to September 2009 trough in the annual rate of inflation. Chart.3 highlights strong run ups in energy and commodity prices due to the recovery in global economic activity.  In the early parts of 2009 oil and metal price growth led agricultural products. However, from mid 2010 the price of foodstuffs has risen at a faster pace. However, the rate of growth in agricultural commodity prices has slowed.  The strong surge in agricultural and industrial metal prices as measured by S&P Goldman Sacs Commodity Index (S&P GSCI) has meant the spread in the annual change in overall CPI and CPI excluding energy has been smaller.

Summary

Energy and commodity prices spikes have resulted in higher levels of overall inflation. Will the BOE respond by tightening monetary policy? The response of the BOE will depend on whether this impact is transitory or permanent. Have consumers’ and businesses’ medium term inflation expectations risen? Will raising interest rates derail the fragile economic recovery, especially given the coalition government’s tight fiscal policy? Energy and commodity prices are determined by the global markets. Are higher domestic interest rates able to counter balance rising global demand from emerging markets? Economists that are in favour of tighter monetary policy argue that an increase in sterling can cushion rising commodity prices. India and China, the primary drivers of global demand for commodities have adopted less accommodative monetary polices. This could result in slower growth and a weakening in demand for commodities.  In short, there is much uncertainty about the current economic backdrop for UK. We are still to see and feel the full impact of the government’s fiscal retrenchment. The latest UK GDP figures for Q4 2010 reported a weather induced 0.6% decline in output. There is still significant capacity in the UK economy with unemployment at a 17 year high of 8%. Additionally, wage growth has remained subdued, indicating that workers are not demanding increased compensation for loss of purchasing power.  The Phillips curve lives: growth or inflation. With elevated unemployment levels, it is difficult to justify higher rates.

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About proprateanalyst

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This entry was posted in Commodity Price, Consumer price Inde, Import Price, inflation, Interest Rate, Oil price, vat and tagged , , , , , , , , , , , , , , . Bookmark the permalink.

One Response to Inflation and Oil Price

  1. esther says:

    thanks i really enjoyed the article….very informative and helpful in understanding trends

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