August 6, 2008 5:02PM

A Falling Oil Price Is NOT Lower Inflation

By Alan Reynolds

I recently explained that, “If [the price of] oil keeps falling, then headline inflation will drop below the ex‐​energy rate, and the ex‐​energy rate will itself drop thanks to cheaper transportation and petrochemicals.” This followed my equally controversial (at the time) June 3 column, “Get Ready for the Oil‐​Price Drop.”


Blogger Stefan Karlsson thought I had said “inflation is not a problem.” Huh?


What I said was that a monthly or year‐​to‐​year increase in the overall CPI “gives us a fair picture of what has happened to the cost of living over the past month or year. But it’s near‐​useless for telling us where inflation is headed in the future.” 


I offered a graph and several examples. The price of oil fell this February, for instance, and that month’s CPI was unchanged — zero. Did that mean inflation was zero? Of course not. Should the Fed have eased that month because oil prices fell? Of course not. So why couldn’t reporters follow that same common sense when oil prices spiked in June?


The May 1991 CPI was 5 percent from a year earlier, I noted, “but it dropped to 2.9 percent within five months, as oil fell 35.3 percent.” When that happens again this year, it will not mean inflation is any less of a problem than it is right now. It will just mean the price of oil came down.


What I wrote is backed by recent research within the Federal Reserve:

  • Todd Clark of the Kansas City Fed found “the CPI ex‐​energy offers statistically significant explanatory power for future [headline] inflation.” 
  • Robert Rich and Charles Steindel of the New York Fed found “the ex‐​energy measure generally maintained its better forecasting record for … inflation over the longer sample period.”
  • On a closely related topic, Rajeev Dhawan and Karsten Jeske of the Atlanta Fed found that “using headline inflation” to guide Fed policy “appears to be a bad idea, both in terms of the output drop and the inflation impact.” 

Those who thought the Fed should have raised interest rates in June because oil prices pushed the CPI up will soon be logically obliged to say the Fed should keep interest rates low or lower just because falling oil prices will be pushing the CPI down. I agree with Dhawan and Jeske on this. I think the Fed should and will raise the (fed funds and discount) interest rates on bank reserves. But I won’t revise that opinion with every up and down in the price of oil.


Disclosure: I own shares in an ETF that shorts oil (DUG) and a mutual fund than shorts precious metals (SPPIX). This is called putting your money where your mouth is. SPPIX was $16.81 on July 18 when my inflation article appeared, but up 26% to $21.22 by August 5.