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Higher Rates of Inflation May Be Around the Corner

August 17, 2016

Ever since the financial crisis and the start of the Federal Reserve’s policy of Quantitative Easing (printing money to purchase bonds as a way of injecting new money into the financial system) there has been a vocal group of market pundits arguing that hyperinflation is just around the corner. To date those predictions have proven incorrect, as the official national inflation rate has averaged just 1.67% since 2009, well below the long-term historical average. However, recent price data may support the view of those predicting higher rates of inflation in the future.

Recently inflation has been tame. Over the past 12 months the official inflation rate was just 1.05%. However, in recent months inflation has picked up steam returning to an annualized rate of over 1.5%. But it is important to note that oil prices have been a large deflationary force for some time. 

In 2013 the price per barrel of reached its post-crisis high of $106 per barrel. Since then oil prices declined steadily until February 2016, when it bottomed at $26 per barrel. Oil prices then rebounded throughout the spring of 2016, pushing above $50 before falling back to $42 currently.

Oil is a major input to the US economy primarily through its effects on transportation costs. As the price of oil declined from 2013 to early 2016 it had a large deflationary impact on official inflation rates. This kept inflation low even as owner equivalent rents, a guage of housing costs, increased significantly with the recovery in the housing market and double digit increases in rents in some metropolitan areas.

Going forward, the disinflationary impact of oil prices may reverse as the year-over-year price change reverts from a decrease to an increase. For example, in May 2015 the price per barrel of oil was $59.27 compared to $46.83 in May 2016. This represents a 21% decrease in the price or oil for the year to May. However, in August 2015 the price per barrel of oil had fallen to $42.87. Therefore, should the price of oil remain at its current level of $42 its deflationary effect will be virtually negated. In addition, should oil prices remain stable through the remainder of the year its effect may shift from deflationary to inflationary as the comparison price from the year earlier decline. For example, should the price of oil remain at $42 per barrel through December the year-over-year price change would be 13%. By January and February the affect would be an increase of nearly 40%. Of course if oil prices decline in coming months the inflationary impact may be reduced. However, if oil prices continue to recover the projection of a 40% year-over-year increase in prices may prove to be two conservative. Either way, oil prices are unlikely to be a source of deflation in the future.

Should other areas of the economy, such as housing prices, continue to display signs of inflationary pressures at the same time that the deflationary impact of oil prices decline or reverse the official inflation rate may increase. While this does not support a case for hyperinflation as some have predicted for some time it does support an argument that inflation may return to its long-term average of 3.0-3.5%.