Rising oil prices raised core inflation notably until the mid-1980s. In particular, we estimate that a 10% increase in oil prices in the early sample boosted (annualized) core inflation by an average of around ¼ percentage point during the following six quarters. But, second, the pass through from oil price shocks into core inflation has since the mid-1980s been negligible. Although a variety of competing explanations have been put forward—including the declining share of oil in US production and increased flexibility in wage setting, improvements in the credibility of monetary policymaking are the compelling reason. As inflation expectations have been very stable in recent years, second-round effects of oil price increases via the wage-setting process are small.

Currently, a key policy question is how the rise in commodity prices will impact headline inflation and “core” inflation (headline inflation excluding prices from the volatile food and energy sectors). The answer depends critically on the behavior of inflation expectations. If expectations remain well anchored and the rise in commodity prices proves to be transitory, as policymakers anticipate, then the current gap between headline and core inflation would likely be closed by a decline in headline inflation.In contrast, a rise in inflation expectations would provide a channel for commodity price increases to pass through to prices in general—as measured by core inflation. The pass—through would occur via increased wage pressures and attempts by firms to pass on higher production costs to their customers. In this case, the current gap between headline and core inflation would likely be closed in part by a rise in core inflation.

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