High Oil Prices are Deflationary

Common intuition might suggest that when oil prices rise, it should lead to higher inflation. After all, oil is a crucial input into almost every facet of the economy, from transportation to manufacturing. Therefore, when oil prices rise, overall prices rise. However, the reality is more complex, and an in-depth analysis reveals that high oil prices actually have a deflationary impact on the economy. This can be summed up succinctly with the old saw: the cure for high prices is high prices.

The Perception of Inflationary Pressures

One of the primary reasons people tend to associate high oil prices with inflation is the visible and immediate impact it has on consumers. When gasoline prices surge at the pump, individuals feel the pinch in their wallets. This perception is reinforced by media coverage, which often highlights the rising cost of gas as a harbinger of broader price increases. Additionally, consumers may experience rising prices for goods and services that rely on oil, such as air travel, delivery fees, heating, groceries, etc.

Furthermore, the historical correlation between oil prices and inflation is another factor that bolsters the belief in their inflationary effect. For much of the 20th century, there was a strong positive relationship between oil price spikes and overall inflation, particularly during the oil crises of the 1970s and the financial bubble of the early 2000s. This historical precedent may lead people to assume that high oil prices will inevitably lead to inflation.

The Deflationary Impact of High Oil Prices

While the perception of oil price-driven inflation is widely held, it's actually a case of mistaking correlation with causation. In reality, inflation (which is an increase in the currency supply) affects energy prices early and more visibly than other prices, so inflation causes high oil prices, not the other way around. At best, oil acts as a medium through which to spread inflation, but is not the root cause. High oil prices in fact exert a moderating and deflationary force on the economy, just like tight monetary policy. Several key arguments and empirical evidence support this somewhat counterintuitive perspective:

• Reduced Consumer Spending: High oil prices act as a de facto tax on consumers, as they allocate a larger portion of their income to cover essential energy costs. This leaves less disposable income for discretionary spending, which has a dampening effect on demand for non-essential goods and services. This reduced consumer spending leads to decreased prices in various sectors, as businesses need to lower prices to attract customers who are squeezed by higher energy expenses.

• Higher Production Costs: High oil prices significantly increase the production costs for many industries. In an attempt to maintain profit margins, businesses are forced to cut costs elsewhere, which leads to selective sourcing, reduced wages, layoffs, and increased automation. This downward pressure on producer inputs and labor costs has a deflationary effect on wholesale prices and wages, just like increased borrowing costs do when the Fed raises interest rates.

• Exchange Rates: High oil prices often lead to trade imbalances, as oil-importing and goods-importing nations experience a surge in their import bills. To cover these costs, countries strengthen their currencies by increasing interest rates or engaging in currency interventions. A stronger currency leads to lower import prices, further contributing to deflationary pressures.

• Technological Advances: High oil prices incentivize research and development into alternative energy sources and energy-efficient technologies and production methods. This can lead to long-term productivity gains, reducing the cost of energy for businesses and consumers and mitigating inflationary pressures in the future.

• Central Bank Response: Central banks typically respond to inflationary pressures by raising interest rates. Like high oil prices, as described above, high interest rates exert deflationary force on businesses and consumers. Typically, central banks try to rely on "core" inflation measures — which exclude food and energy — in guiding policy-making decisions. However, the populace most feels the inflationary pressure in food and energy prices, so persistently high oil prices create general discontent and reactionary political blowback which tends to evoke tighter monetary policy.

• Oil Producer Response: During an inflationary episode in which oil prices have risen, oil producers want to lock in any gains they've made and not suffer from the subsequent deflationary forces. Therefore, they coordinate oil production cuts as the economy contracts so as to keep supply constrained and ensure prices don't fall very much or too quickly. Thus, even as the economy cools off, oil prices remain high and extert continuing deflationary influence.

Conclusion

While the common perception is that high oil prices drive inflation, a closer examination reveals that they actually have a deflationary impact on the economy. The cure for high prices is high prices because high prices reduce consumer spending, increase production costs, affect exchange rate dynamics, incentivize technological advances, coerce central bank action, and remain "sticky" -- all of which contribute to a deflationary effect on the economy. High oil prices only promote inflation while the currency supply is increasing, i.e. in an inflationary environment. As soon as the currency supply stabilizes or decreases, then the deflationary forces prevail. Understanding this nuanced relationship is crucial for policymakers, economists, traders, and consumers to make informed decisions and also highlights the need to consider the broader economic context.