Is there still a direct link between rising Brent crude oil prices and inflation?

economy inflation May 07, 2019

The Bank of England (BoE) governor, Mark Carney, has recently warned of growing inflationary pressures and potential interest rate rises sooner than was previously expected.

At the moment the UK’s inflation rate is at 1.9%, unchanged from the previous month and well below the ceiling of 2% after which the BoE would have to take action.

However, although the core basket of prices that influence the inflation rate is not seen as the problem, the rising cost per barrel of crude oil may be behind Carney’s latest warning.

The current price of Brent crude oil as of April 29, 2019 is $71.22 per barrel, although the monthly average so far this year has been calculated as $64.98. (Figures courtesy of https://www.macrotrends.net )

The idea of a direct correlation between oil price rises and inflation was cemented in the 1970s when the UK economy was hit by an oil embargo by the 1973 by Arab oil producers in response to Western support for Israel in the Yom Kippur war.

The 1970s inflation rate of more than 24% that toppled the government of Edward Heath and forced the BoE under the subsequent government of Harold Wilson to prop up Burmah Oil was arguably determined by oil prices. The resulting “stagflation” also c9ntributed to global food shortages and escalating Trades Union demands for wage increases to cope with the rising prices.

The link between crude oil prices and inflation was fixed in the minds of economists and central banks although it seems to have been forgotten.

So, should the current rising Brent crude oil prices be reason for concern?

This chart (again courtesy of macrotrends) shows the oil price picture over the last decade:

Brent Crude price fluctuations

The chart highlights the volatility of oil prices with a 10-year high of £128.14 in 2012 and low of £27.88 in 2016.

At today’s price the future trend would seem upwards although most economists now argue that the direct link between price and inflation is no longer relevant because the world has changed significantly.

Firstly, the economists cite the many other oil producing countries outside of the OPEC cartel and why OPEC is no longer dictating prices. These include Iran, Russia, Brazil, China and Canada, with the US being self-sufficient now it produces its own oil.

Secondly, consumer demand for petrol when the oil prices rise does not reduce and some industries do not pass on the rises to consumers via their products.

Thirdly, they argue that the crude oil pricing model is not simply one of supply and demand because the price of oil is actually set by the oil futures market, which is determined by traders and market sentiments.

So where is the BoE warning of inflationary pressures coming from?

According to the Observer’s business leader at the weekend, the BoE latest quarterly review of the economy sees a combination of a reviving global economy and the UK’s ever-increasing workforce –increasing demand and keep up the pressure on prices. This is contrary to other evidence of a global bubble that is growing.

However, the BoE says: “the only reason that economic activity has picked up in the US, the eurozone and China is because their respective central banks have promised to tear up plans for interest rate rises”.

Despite the positive forecast, supply concerns may prop up oil prices due to the USA’s continued embargo on Iranian oil and its re-imposition of sanctions on countries that buy from Iran. It also has an embargo on Venezuela.

Also, concerns about contaminated oil coming via a pipeline from Russia have prompted European customers Poland, Germany and Ukraine to halt imports via the Druzhba pipeline are all contributing to the currently high price of crude oil.

Whether this will feed into rising inflation and the knock on effect of rising interest rates remains to be seen.

Alas, each generation tends to forget history and the 1970s seem a long time ago!

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