Oil Price and Deflation

by: Ivan Kitov

The current turbulence in financial markets and the expectation of a poor economic performance (i.e. recession) in the biggest economies has been accompanied by a dramatic fall in oil price. We have predicted this drop several months ago and expect the price to fall to the level of $70 per barrel by the end of 2011. We will address this prediction when the Bureau of Labor Statistics publishes the PPI and CPI estimates for July 2011. Here we would like to highlight the influence of oil price on the PPI and headline CPI.

The price index of energy comprises approximately 10% of the headline CPI is highly correlated with oil price. The surge in oil price observed since the beginning of 2011 (Figure 1) has been the most important driver of the elevated consumer price inflation. Accordingly, many economic and financial experts expect a period of hyperinflation in the near future. However, oil price has been falling. This fall resulted in a negative rate of monthly inflation in June 2011. In July, the monthly rate of inflation is likely to be positive because the price index of energy (oil) did not fall much relative to June.

The monthly rate of inflation is an important but only a transient indicator of the overall price change. Therefore, we have calculated the annual rate from the curves in Figure 1, where red line is the original price index (black line) shifted by one year ahead. The ratio of black and red line is the rate of oil price inflation, as shown in Figure 2. The rate of inflation is characterized by two peaks in 2008 and 2010. Obviously, the rate of inflation is defined by two factors: the current level of oil price and that one year ago. The difference between black and red line can be considered as a crude estimate of the inflation rate. When red line is above black line, the rate of inflation is negative. Otherwise, the rate is positive. What can we expect in 2012 with the price index of oil falling through the third and fourth quarters of 2011? Almost inevitably, the rate of (oil price) inflation will be negative through 2012. Since other components of the headline CPI also demonstrate the tendency to fall one can expect a period of deflation in 2012.

Figure 3 presents our estimate of the oil price evolution in 2011. We expect the price to fall by $6 per month to the level of $70 in December 2011. We also expect the price to fall through 2016 and put the uncertainty bounds for the long-term trend in oil price. The level of oil price in 2016 is between $30 and $60 per barrel.

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Figure 1. The (producer) price index of oil (domestic crude petroleum). Red line is the original price index shifted one year ahead. The ratio of black and red line is the rate of oil price inflation shown in Figure 2.

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Figure 2. The annual rate of oil price growth.

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Figure 3. Oil price prediction in 2011. The price is expected to fall by $6 per month between June and December 2011. The price level is $70 in December 2011. We also show the range of expected price evolution by 2016.

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