IE 11 is not supported. For an optimal experience visit our site on another browser.

Why haven't energy prices stoked inflation?

/ Source:

Q: If the Consumer Price Index and the inflation rate fully reflected oil prices this year, the U.S. inflation rate would be up well over 30%, even more in some regions. Purchasing gasoline and natural gas is part of the cost of living, isn't it? Of course politicians from both parties wouldn't be bragging about economic growth and consumer purchasing power if the inflation rate truly reflected the rising oil prices. Joseph P., Chicago

A: The answer depends on whose inflation rate you're using.

When the Fed’s rate-setting committee met this week -- and decided to raise rates a quarter point to 2 percent -– the official line was that “inflation and longer-term inflation expectations remain well contained.” But with energy prices surging –- and –- how can that be?

There are two reasons. First, energy costs still make up a relatively small portion of the “average” U.S. household’s budget. Second, American businesses and consumers are using that energy more efficiently than they did 30 years ago, when a similar surge in energy prices sent inflation soaring.

Granted, you don’t care nearly as much about this abstract measure of the health of the U.S. economy as you do about your own financial well-being. So if you’re spending more on gasoline for a long commute, or you live in a cold weather state and burn lots of heating oil, your “personal CPI” is going to be a lot higher than the published figures.

To see why this is, take a look under the hood of the Consumer Price Index. This widely watched inflation measure is calculated by giving a fixed “weight” to over 2,000 consumer spending categories -– everything from breakfast cereal to medical supplies to haircuts. Those weights are based on detailed surveys of the spending habits of thousands of families and individuals. The raw data is then “seasonally adjusted” to take into account changes in spending patterns throughout the year. (We tend to buy more sunscreen in the summer, for example, and spend less on sweaters.)

In the case of energy prices, the good folks down at the Bureau of Labor Statistics figure that the “average” American household spends 4.741 percent of its budget on “fuels and utilities” and another 3.249 percent on “motor fuels.” (Now that energy prices have risen since past year, the “weight” of those categories will likely go up when the BLS re-jiggers its formula in December, as it does every year.) For now, energy costs officially make up about 8 percent of the overall inflation rate. So even with gasoline prices up 31 percent (on average) from a year ago, that increase only adds about 1 percent (3.249 percent of 31 percent) to the overall cost of living.

What about indirect costs? You might expect that higher energy prices would also have an impact on the cost of every product made or service provided that requires energy. But so far, most of that additional cost hasn’t been passed along to consumers. Instead, higher energy prices are acting like a tax on businesses, slowing profit growth and, in turn, the growth of the overall U.S. economy.

Take airlines, for example. There’s little doubt that higher jet fuel costs have hit that industry hard – harder than most. But try as they might to pass along extra fuel costs – through fuel surcharges or higher ticket prices – consumers just won’t go along. With more seats than passengers and Web sites offering instantaneous pricing showing the lowest fare, the airlines have no choice but to eat the cost. (That can’t go on forever. With two of the biggest U.S. airlines in bankruptcy and other major carriers bleeding cash to stay in the air, some of the “excess capacity” in the airline industry may soon be eliminated if one or more of those airlines shuts down.)

For other industries, higher energy prices also hurt, but not as much as they did in the 1980s. Adjusted for inflation, a barrel of crude would have to hit $80 before it reached the peak hit in the 1970s. And the oil shock of the 1970s created a huge national effort to become more energy efficient. The result is that the amount of oil used to produce each dollar of GDP today is about half what it was 30 years ago.

Or, as Mr. Greenspan put it in October: "The impact of the current surge in oil prices, though noticeable, is likely to prove less consequential to economic growth and inflation than in the 1970s.”

Then there are other forces keeping non-energy prices down. When a manufacturer moves its factory to China to take advantage of lower wages, it can make the same number of widgets for less money. That labor cost savings can go to one of two places: it can boost the manufacturer’s profits, or it can help cut the retail price tag of the widget. When Wal-Mart is your distributor, the choice is made for you: you cut your prices.

The bigger threat to inflation may be from the falling dollar. With more and more products made overseas, your paycheck buys less and less of those products as the dollar falls. Put another way, you have to pay more of your hard-earned dollars for the same foreign-made widget. That’s a textbook case of price inflation.