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Are rising gas prices a sign of inflation?

Picture of high gas prices at a gas station

REUTERS/Mike Blake

A rise in gasoline prices is not a measure of inflation, and it’s worth taking some time to understand why.

Last Friday, the Bureau of Labor Statistics (BLS) reported that Consumer Price Index (CPI) rose by 0.4 percent in February and was 2.9 percent higher in 2012 than it had been in 2011.  In plain English, this means that inflation is quite low.

You might respond: “OK, but what about gas prices? They’ve gone up 20 percent since November! Isn’t that inflation?”

My short answer is no. A rise in gasoline prices is not a measure of inflation, and it’s worth taking some time to understand why.

Relative prices and price levels

The average price per gallon of gasoline rose from about $3.27 in November to $3.58 in February, an increase of roughly 10 percent. Is this a big increase or a small one? Is $3.58 a high price?

Prices such as $3.58 per gallon of gasoline, or $1.50 for a loaf of bread, don’t give us enough information to answer these questions. We need benchmarks against which we can compare the price of gasoline relative to a loaf of bread and the other things we buy, both today and over time.

Economists use price indices as our benchmarks. A price index measures the overall level of prices at a particular point in time. For instance, the Consumer Price Index (CPI) measures the general level of prices for goods and services that a typical household purchases each month. (A nice summary of the details is here.)

We can use a price index to analyze what is happening to the price of a good such as gasoline relative to the general level of prices over time. The blue line graph below shows the price of gasoline in dollars per gallon without comparing the price to the CPI (in other words, without adjusting for inflation). The red line traces the price adjusted for the fact that the CPI changes from month to month (in other words, adjusted for inflation).

I started driving in 1976 and the price of gas was about $0.50 per gallon and now it’s around $3.50 — an increase of about 600 percent.  But when we consider the changes in the overall level of prices, the adjusted (or real, to use economics jargon) price of gasoline was about $0.88 in 1976 when we convert the price to the average level of prices in 1982-1984, which is the base year for the CPI. (Why 1982-1984?  It’s arbitrary; see this article for more.) The price of gas is now roughly $1.57 in 1982-1984 dollars, so in real terms the price of gas is twice as expensive as when I got my driver’s license, not seven times higher.

(By the way: you can do calculations like this quite easily using calculators that are available on the web. Two of my favorites are MeasuringWorth.com and the Minneapolis Federal Reserve calculator. Did you know, for example, that a first-class train ticket from Washington, DC, to New York was $13.36 in 1956, which translates into $114.19 today? A business class seat on Amtrak is about $120 today. Not bad!)

Inflation and the inflation rate

I haven’t yet defined the word “inflation.” Now we’re ready: inflation is a rise in the general level of prices as measured by a price index like the CPI. Inflation is not a rise in the price of a particular good or service, such as gasoline. An increase in real gas prices, like that shown in the graph above, is called an increase in the relative price of gas. And the rise in the nominal price of gasoline (i.e., the blue line in the graph above) is meaningless since it doesn’t compare gas prices to any standard such as a price index or the price of another good.

The inflation rate measures the speed at which prices are rising and is calculated as the percentage change in the CPI. So when the BLS announced that the CPI was 2.9 percent higher in February 2012 than in February 2011, this meant that over the course of that year the general level of prices rose at rate of about 3 percent per year.

The chart below shows two types of inflation rates. The blue line shows the inflation rate calculated using the CPI.

Notice that this inflation rate is pretty volatile — see, for instance, the jagged line in 2009. To deal with this problem, economists use another measure called the core inflation rate. Core inflation is the rate of increase of all prices except energy and food, the two items most frequently responsible for short-run fluctuations in the inflation rate. Because core inflation excludes the sources of the most volatile price changes, it is considered to be a useful short-term measure of the underlying inflation trend. 

The red line shows the core inflation rate. It indicates that inflation has risen over the past year, but only from about 1 percent per year in February 2011 to 2 percent in February 2012. A 2 percent inflation rate is the target inflation rate of virtually every central bank in the world, including the Federal Reserve. Thus inflation is about where the Fed wants it to be.

Should we be worried?

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The inflation rate today is quite low, and has averaged about 2 percent per year for the past 10 years. Gas prices have been rising faster than this, but when adjusted for inflation, they are at roughly the same level they were before the financial crisis of 2008. Increases in the prices of individual products, such as gasoline, tell us nothing about inflation because inflation is a rise in the general level of prices, not a jump in the price of one good.

What about the future?  Should we, to quote a recent column in the StarTribune, “Prepare for impact: Inflation's tide will soon be rushing in”? No, I don’t see inflation exploding or even rising significantly in the near future. A combination of faulty theoretical reasoning and inappropriate historical analogies is leading many to make this claim. I’ll work through the details next week.

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Comments (10)

At some point demand WILL

At some point demand WILL exceed supply.

Are there any studies as to the effect that will have on inflation and the economy when there is a true shortage of a necessary good?

On hint comes from the analysis of power prices in the recent Texas heatwave:

http://205.254.135.7/todayinenergy/detail.cfm?id=3010

The cost of buying power on the open market rose from $45/MWh to $3000/MWh in the hottest periods of the hottest day. ($3000/MWh was the artificial cap price).

Oil is finite

First off, the Consumer Price Index (CPI) does NOT count food or energy prices. http://www.bls.gov/cpi/cpifaq.htm

Second off, oil is a finite substance. We have "extracted," rather than "produced" the cheap, easy to find light, sweet crude oil in domestic places such as Texas, Pennsylvania, and Alaska. We are now either seeing declines in major oil fields like Ghawar (Saudi Arabia), Cantarell (Mexico), Bergen (Kuwait), Prudhoe Bay (Alaska) or we are extracting the heavy, sour crude in more difficult, expensive locations such as under the Gulf of Mexico, in oil shale such as the Bakken, or in tar sands. This oil costs more to extract, in terms of up front capital, and has a lower return on investment - in money and energy (EROEI - energy returned on energy invested) terms.
http://www.aspousa.org/index.php/peak-oil-reference/why-we-think-all-liq...

Third, our money supply has increased. M1 money supply has grown by $2.5 trillion between 2010 and 2012 thanks to the Fed's easy money policy of 0% interest rates, coupled with QE1, QE2, and QE lite.
http://www.shadowstats.com/charts/monetary-base-money-supply

I will not be surprised if Brent Crude Oil costs $150-$200/barrel in 5 years from now unless we have a major recession. The age of cheap oil is OVER - forever.

That was meant to say M2

That was meant to say M2 money supply.

You're speaking Greek to me

It doesn't matter whether you meant M1 or M2, it's all Greek (or, maybe not Greek, since it's considered a bad economic word these days) to me. I suspect that there's meaning to what you say, and I understand some basic level, but jargon is never good for understanding.

M2 money supply

M2 money supply includes: physical currency in circulation, checks, bank deposits, and institutional money market funds. There is also M1 money supply which is more narrow, and M3 money supply, which is for whatever reason no longer being published by the Fed as of 2006.

QE stands for Quantitative Easing, a program in which the Federal Reserve buys up US Treasuries (rather than China, Europe, Japan, or private banks & individuals) and thanks to fractional reserve banking, this increases the money supply by 10-fold. It is a "stimulus" that is supposed to increase credit markets, but it also has the tendency of being very inflationary. When the money supply increases dramatically, the value of the dollar relative to goods and services decreases, and things cost more.

Thanks

Thanks for the explanation.

Poor Federal Energy Policy

Gas prices have increased due to increased world demand for oil. For national security reasons alone, the U.S. needs to utilize our national resources like every other country in the world. The U.S. balance of payments as well as Federal Tax revenues would increase if U.S. companies could drill & pump oil from our own God given natural resources.

We Will Never Run Out Of Oil

As the low hanging fruit gets picked and we are left with the more difficult to extract oil, the price will rise. As oil prices rise alternative technologies become more competitive. Of course this process is either encouraged or discouraged by forces outside the market, such as huge tax breaks for oil companies or inconsistent subsidies for solar.

The last of the oil will remain in the ground forever.

In the early '80's the predictions were that oil would rise to $100 a barrel by the mid 80's. Instead the price of oil plummeted, Reagan benefited, and prognosticators had to wait another twenty years to be right.

This a well-written piece on a topic that is often poorly covered by the media. Outrage when the price goes up, silence when it falls.

Inflation

When thinking about inflation in terms of supply and demand, it's important to distinguish between whether a price change is due to a change in the value of the currency, or whether it's due to a change in the value of what the currency pays for. This is why many economists focus on the core inflation rate, one that excludes from consideration commodities subject to volatility in pricing. This reflects an understanding that such volatility, while it can have an impact on prices is often due to factors that have little to do with the value of the dollar, that is, inflation or deflation.

Some of the American public

Some of the American public believes whomever is currently president has some control of gas prices. Candidates seeking office do too, according to the Washington Post; now-President Obama blamed then-President Bush for high gas prices while on the campaign trail. Obama is getting blamed now.

For full article: http://personalmoneynetwork.com/moneyblog/2012/06/11/high-gas-prices/

High gasoline costs are a problem, but the unfortunate truth is that they aren't likely to abate and there is next to nothing that can be done. Vote for whomever you like; it matters not to the petroleum commodities market, which has almost everything to do with how the prices are set. The problem with us is we are quick to pin point whose to blame instead of looking for ways to cope up with the present situation. I just hope that our president will make sure that America won't lose jobs and money because of the high price of oil.