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Kimberly Amadeo

Rising Oil Prices Driving Inflation

By February 20, 2012

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High gas and oil prices caused inflation to creep up .2% in January. The Consumer Price Index report showed that gasoline prices rose .9% last month. Another driver of inflation was health care costs, which crept up .6% in January.

Year-over-year, prices were up 2.9%. Gas prices were 9.7% higher than last year. Gas prices usually rise in the spring, in anticipation of the summer vacation driving season. However, they reached the critical $3.50 a gallon earlier this year, thanks to concerns about a possible attack on Iran. In fact, some areas in California and on the East Coast saw $3.50 a gallon gas in January.

Housing costs are also rising, which would surprise those who are trying to sell homes they bought in 2005. That's because rental rates are rising, and the CPI measures rental equivalent rather than home sales. What's a rental equivalent? It's what a homeowner would get if they rented rather than sold their home. For more on this, see How the Consumer Price Index Is Calculated.

The core inflation rate inched up a tad, to 2.3% from was 2.2% in last month's report. However, the Federal Reserve said it is comfortable with a core inflation rate at around 2%, which is its inflation target . Fed Chairman Ben Bernanke adopted inflation targeting to make his policies more transparent.

Why does the Fed use the core inflation rate? It doesn't include volatile food and gas prices, and so is a better guide for slow-acting monetary policy. Tools like the Fed funds rate, the discount rate and even quantitative easing take time to affect economic growth. If the Fed raised interest rates (to prevent inflation) every summer when oil and gas prices spiked, it wouldn't slow economic growth until the winter, when prices drop anyway. This is known as stop-go monetary policy, and its what caused stagflation in the 1970s.

What It Means to You

Gas prices are rising, which is the most noticeable effect of inflation. Why is that? Because demand for gasoline is inelastic. That means it is difficult for you to change your driving habits quickly. You pretty much have to pay whatever the going rate is for gas until you can develop another method of getting around. Gas is something you need every week, so you can't put off the purchase until prices come down, like you can with a TV or iPod. (Source: BLS, Consumer Price Index, February 17, 2012)

Your Opinion: Which Is the Bigger Concern - Inflation or Recession?

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