(Riccardo Trezzi was interviewed on BloombergTV this morning. You can see the video here)
In this quick note we provide a useful rule-of-thumb to map oil movements into headline and core CPI/PCE price inflation. Given today’s shock, all else equal, we should expect headline inflation to be pushed up by 0.2%-0.3% in the next 3 months. The implications for core inflation are minimal.
Our research
The rule of thumb: 10US$ movement in Brent results in 24cents at the pump. Figure 1 shows retail gasoline prices (national average, all grades) in the US together with Brent. Both series are plotted in US$ per gallon (reminder for non-Americans: one barrel is 42 gallons). The gap between the two series is roughly constant over time and the passthrough from crude to gasoline is pretty quick (80-90% of the shock is reflected in 3 months). The rule-of-thumb implied in Figure 1 is as follows: a 10US$ move (up or down) results in 24cents at the pump within 3 months (the 24cents are calculated as 10US$ divided by 42).
Figure 1. Retail gasoline prices and Brent
We can expect 0.2%-0.3% upper pressure on headline CPI/PCE price inflation. Because the relation between Brent and gasoline prices is in levels, a 24cents move can be more or less inflationary depending on the starting level of gasoline prices. At the time of this note, average gasoline prices in the US are at 3.42US$ and the front contract of crude oil is up about 5US$. Therefore, retail gasoline prices are expected to go up 3.5% (from 3.42US$ to 3.54US$) in the next 3 months. Taking gasoline prices as a proxy for all “energy” items in the CPI/PCE baskets (an upper bound estimate), and considering the weight of energy in CPI (7%) and PCE (4.5%), all else equal, it is reasonable to expect headline inflation to be pushed up 0.25% and 0.16% respectively in the next 3 months.
As for core inflation, the implications are trivial. According to our models, a 10% move in crude oil results in 6bps (4bps) in core CPI (PCE price) inflation after 8 quarters. Therefore, in the current environment we can consider this shock as negligible.
Conclusion
Unless we get a 30US$ crude oil shock, monetary policy should not care. The literature (see here for instance) has pointed out that, contrary to a popular belief, inflation is not driven by commodity/oil prices. A monetary authority should not care about movements in crude oil prices, unless they affect (long-term) inflation expectations. In this note we have provided a rule-of-thumb to quickly map oil movements into headline inflation space. Having said so, the implications of today’s crude oil movements are trivial for the Fed (and the ECB as well).