Oil prices, US inflation, US money supply and the US dollar

• Author: Samih Antoine Azar
• DOI: http://doi.org/10.1111/opec.12008
• Date: 01 December 2013
• Published date: 01 December 2013

Oil prices, US inflation, US money supply

and the US dollar

Samih Antoine Azar

Associate Professor, Faculty of Business Administration and Economics, Haigazian University, Mexique

Street, Kantari, Beirut PO Box 11-1748, Lebanon. Email: samih.azar@haigazian.edu.lb

Abstract

A central proposition in many macroeconomic models is price stickiness, while it is agreed that

commodity prices are determined in auction markets, and are necessarily fully flexible.The overall

price level is a weighted averageof commodity prices and consumer prices. An exogenous increase

in the money supply,keeping everything else constant, increases the overall price level proportion-

ately. Because of stickiness of consumer prices, commodity prices overshoot the increase in the

money supply.The purpose of this paper is to re-examine the relations between the price of one spe-

cific commodity which is oil with US inflation, US money supply and the US dollar.One empirical

fact is that during the sample period, global and US demand shocks have raised oil prices immedi-

ately whiletheir effect on consumer prices was delayed. This overshootingof oil prices is expected to

occur in the short run and to wane in the long run as consumer prices fully adjust. The overshooting

of oil prices is the mirror image of the overshooting of the US dollar. This is true for two main

reasons. One, both oil and the US dollar react in the same manner to money supply changes.Two,oil

prices are quoted in US dollars and a depreciation of the US dollar is instantly compensated bya rise

in the US price of oil. Additionally, the paper analyses and discusses the evidence on an apparent

long run overshooting of oil prices and explainswhy it is just a statistical artefact that stems from the

salient features of oil.

1. Introduction

Most of the empirical research that inquires about the relation between the prices of

commodities and inflation uses indexes of commodity prices (Webb, 1988; Garner, 1989;

Surrey, 1989; Marquis and Cunningham, 1990; Sephton, 1991; Pecchenino, 1992;

Blomberg and Harris, 1995; Furlong and Ingenito, 1996). The general message is that the

price level and an index of commodity prices are not cointegrated,i.e. they do not move in

tandem in the long run (Garner, 1989; Sephton, 1991; Pecchenino, 1992; Furlong and

Ingenito, 1996). Many find the consumer price level integrated of order two,meaning that

second differencing is needed to render the series stationary (Sephton, 1991; Furlong and

Ingenito, 1996). Some of this research is directed to the study of whether commodity

387

© 2013 The Author. OPEC Energy Review © 2013 Organization of the Petroleum Exporting Countries. Published by

John Wiley & Sons Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

prices can act as leading indicators of inflation, and thus help in the design of monetary

policy (Marquis and Cunningham, 1990).

The interest in this paper is not in commodity indexes but in a specific commodity,

which is oil. The relation between oil prices and the macro-economy has been studied

extensively. The earliest research is in the 1980s (Hamilton, 1983), just after the oil

price shocks of the 1970s. For some recent analyses, see Lescaroux and Mignon (2008)

and Kilian (2008, 2009). Although these authors study the relation between consumer

prices and oil prices, which is one purpose of this paper, their results are not comparable

with those in this paper because their variable is the real change in oil prices, whereas

the variable in this paper is the nominal change in oil prices. Besides, the previous

authors do not report the direct estimates of the short or long run impacts of real oil

price changes on inflation. For example, Kilian (2008, 2009) reports only impulse

response effects over time, for as long as 15 months (Kilian, 2008), or for as long as 12

quarters (Kilian, 2009).

One purpose of this paper is to re-examine the relation between oil prices and the US

inflation. A non-exhaustive list of the recent literature on the topic is LeBlanc and Chinn

(2004), De Gregorio et al. (2007), Chen (2009), Clark and Terry (2009), Jacquinot et al.

(2009) and Crowley (2010). The usual research question is to ask by how much do

changes in the price of oil impact the US inflation rate? A special term has been assigned

to describe this impact: the pass-through of oil prices onto inflation. The underlying

assumption is a cost-push transmission mechanism from oil prices to inflation. If true,

such a mechanism is expected to hold especially well in small open economies. However,

Crowley (2010) fails to find a positive relation going from oil prices to inflation in his

sample of developing countries. In fact, Crowley finds a perverse negative relation in

some cases. De Gregorio et al. (2007) also document a negative pass-through forAfrican

economies.

A common usage in the literature is to adopt a structural break in the sample: pre-1984

and post-1984 (Blanchard and Gali, 2007). Hooker (2002) concludes that the oil pass-

through has become negligible after 1980. Clark and Terry (2009) find an insignificant

pass-through after 1985, and LeBlanc and Chinn (2004) report a small but significant

pass-through for the US economy that lies between 0.07 and 0.08. De Gregorio et al.

(2007) estimate with a panel regression consisting of 34 countries that the pass-through

has fallen from 0.15 to 0.03 after the 1980s. For the United States their pass-through esti-

mate declines from 0.08 to 0.03 after the 1980s. Since the sample in this paper starts in

September 1985, it is expected that this sample will be homogeneous and that it will not to

suffer from any structural break.

Most studies on the oil pass-through have naturallyconsidered the change in oil prices

as exogenous.The direction of causality is assumed to run from oil prices to inflation. This

paper documents a reverse causality wherebyoil prices tend to overshoot consumer prices.

Samih Antoine Azar388

OPEC Energy Review December 2013 © 2013 The Author.

OPEC Energy Review © 2013 Organization of the Petroleum Exporting Countries