Wednesday, September 13, 2006

Energy prices: inflation or growth pressure?

Do rising energy prices cause inflation or do they weigh on growth? This debate has been raging for most of the last 2 years, as oil prices seem to have continuously risen. Now, with gas prices down around 20% over the last couple months, the debate has reversed: will falling prices stoke growth or ease inflationary pressures? The WSJ wrote an article posing just this question today.

In my opinion, its a matter of general corporate pricing power. Gasoline is an input in almost every physical good produced anywhere, because almost every thing needs to be shipped at some point during the production cycle. So if producers have strong pricing power, they will pass the increased cost onto consumers. That's inflationary. If they don't have any pricing power, it just hurts profits. That hurts growth.

I'd argue that producer pricing power has a lot to do with how easy monetary policy is. So if the Fed wants to be sure rising energy prices don't pass onto consumers, they should keep rates elevated. Granted, that would mean the Fed is intentionally choosing to harm growth to protect against inflation, but I think that's a trade-off the Fed will accept.

So I'd argue that if gas prices stay lower, that will improve U.S. growth, all else being equal.

What does this do for inflation? Probably not much right now. From an expectations theory perspective it could have a significant impact. I've argued that gas prices are a dominant factor in how average consumers view inflation. Gas is highly volatile, people buy it repeatedly, and every one sees the price advertised prominently as they are driving down the street. No other price is quite like that. Most consumers also remember the inflationary impact of gas in the late 70's. Put that all together, and I think regular consumers see higher gas and think inflation.

The Fed is very concerned with inflation expectations, so if the decline in gas continues and inflation expectations diminish, that could give the Fed some comfort.

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