The Times is running regular briefings to coincide with Target Two Point Zero, the Bank of England contest for sixth-formers run in conjunction with the newspaper. The competition challenges students to play the role of the Bank of England’s Monetary Policy Committee and recommend the best level for interest rates.

This week: the impact of oil and commodity prices on inflation and rates.

What has happened to oil and commodities prices recently? Crude oil prices this month hit record levels of $98.62 per barrel in New York and $95.19 per barrel in London. Having surged two years ago and then fallen back, they have now nearly doubled in the past year, pushed up by supply concerns, strong demand from emerging markets and the fall of the dollar, the currency in which oil is priced. Some have suggested that speculators are pushing prices higher, but the effect has lasted longer than most predicted. It is a similar story with commodities. A crucial factor is the vast amount of raw commodities being consumed by China, particularly metals.

Why is a rising oil price relevant to the inflation rate? The most obvious impact of oil prices on the economy is through the costs of fuel for transport and distribution of goods, for travel and for heating.

Higher oil prices quickly feed through to the cost of petrol, diesel and aviation fuel and these items can push up inflation. Oil is also a key raw material in many products, from plastics to textiles. A change in the price of any raw material affects a company’s cost base and it must decide whether to pass on the change to customers. Companies sometimes absorb higher costs, accepting lower profits to avoid antagonising customers. The extent to which they do this influences inflation.

Are companies passing on those costs at the moment? Economists measure changes in costs and the extent to which they are passed on to the consumer through producer input and output prices, which measure the cost of manufacturers’ fuel and materials and the price at which they sell their products. The latest statistics, for October, show that UK producer input prices have risen by 8.6 per cent from a year before. Producer output prices were up by 3.8 per cent. It is a worrying sign that companies are passing on higher costs.

Is it inevitable that we will have higher interest rates? No. Dealing with higher oil prices is complicated for central banks because they must also weigh up the effect on demand. Bigger fuel bills leave consumers and companies with less to spend on other goods and services. In turn, this reduces demand in the economy, cutting inflationary pressure.

So an oil spike can be inflationary and deflationary. How does the Bank decide which effect is stronger? It is not easy. A key issue is whether the initial rise in inflation triggered by an oil price rise results in so-called “second-round effects”. These occur when increased inflation leads to higher wage demands, or when companies pass on the rising costs.

www.timesonline.co.uk/targettwopointzero

www.bankofengland.co.uk/education/targettwopointzero

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