The chart below shows the trends in the rate of inflation as measured by producer input and output prices over the last decade.

After falling sharply through 1997 and 1998, oil prices rose equally sharply through 1999 and 2000.

Reflecting this, the input price index fell consistently over the earlier period - by the end of 1998 the index was nearly a fifth lower than two years earlier - before bouncing back in the next two years.

The bounce back proved temporary, however, with weak global activity through 2001 and 2002 resulting in fragile commodity prices generally and oil prices in particular. For a time in late 2002/early 2003, the threat of war in Iraq pushed oil prices up but these concerns were short lived and by the middle of 2003 input prices were once again weakening in response to inadequate global demand.

By 2004, however, the pressure on oil prices returned with prices rising through to the first half of 2006, peaking at $77 a barrel in August. The consequences for the UK economy included higher fuel bills for households, helping to push the headline rate of inflation above the official ‘target’ rate of 2%. During the autumn, however, prices drifted back down, and by October were a tad below $60.

Prices remained stable for around six months but by March 2007 started to rise again, reflecting the strength of world growth. By February 2008, oil prices passed the $100 mark eventually peaking at nearly $150 in the middle of the year when increasing concerns about the global economy were sufficient to cause prices to tumble.

By the end of 2008, prices were back in the $30 - $40 range, before recovering to around $70 by the summer of 2009.

The rollercoaster ride in the price of oil has been caused by imbalances between demand and supply. Global demand for oil, for instance, has been increasing over time, partly thanks to the growth of China (which after the USA is now the second-largest importer of oil). China’s demand is driven not only by rapid industrialisation but also by growing consumer demand, with some forecasts suggesting that by 2020 China will have more private cars than the United States.

Over the five years to 2007, Chinese GDP grew by an average of over 10% a year in real terms compared with an average 3.3% increase in world GDP.

Demand, though, is only half the story, and supply considerations are equally important: as oil prices tumbled in the autumn of 2006, the OPEC group of oil-exporting countries agreed in October to cut output by 1.2 million barrels per day (bpd).

Those cuts were only partially implemented, and by early December industry analysts suggested that output was down by only some 750,000 bpd. (This is not the first time that cuts have proved difficult to enforce, as individual countries are often reluctant to sacrifice revenue.)

Nevertheless, they succeeded in holding price at around $60 a barrel and, at a subsequent meeting in December, OPEC ministers agreed to further cuts of 500,000 bpd, starting in February 2007.

A similar story occurred towards the end of 2008. At the beginning of September OPEC announced that output would be cut by 500,000 bpd to correct the huge oversupply which had been caused by slowing economic growth and a stronger US$. The figure was raised to 2.2 million bpd in at OPEC’s December meeting although it was admitted that the earlier resolution to cut production had only been 85% successful.

Geopolitical risk

A big source of uncertainty, however, is ‘geopolitical risk’ since much of the world’s oil lies beneath unpredictable political regimes.

The main focus of this risk is in the Middle East, where the ever-present risk of tensions escalating into military conflict causes endless worry about security of oil supplies. Periodically concerns arise, for instance, about Iran’s nuclear programme and how Israel might react to it.

Other regions, however, have also contributed to the sense of vulnerability: Nigerian output was disrupted in 2006 as armed insurgents waged a campaign which involved attacking oil installations and kidnapping foreign oil workers, while on occasions markets have been spooked by the tirades of maverick Latin American politicians.

Russia has considerable oil reserves: but, although it is now the second-biggest oil exporter (after Saudi Arabia), a suspension of gas supplies to Ukraine in the winter of 2006 highlighted the potential risks to this supply.

The bankrupting of private oil firm Yukos, and the difficulties faced by the international consortium developing the giant Sakhalin-2 oilfield, added to those fears.

The upshot is that, despite some easing in demand pressures, markets continue to price in an element of ‘political risk’.

The return to a low inflation economy has meant that firms have generally found it difficult to increase prices. The huge volatility in their input costs has, therefore, had to met by changes in company profit margins rather than by being passed on to customers.

The chart below (based on the RPI) illustrates how the price of services has risen much faster than the price of goods for the whole of this period. Since 1997, the rate of inflation for services has averaged 4% a year whereas the rate of inflation in goods averaged just 1%. Only at the end of 2007 and through 2008 did that gap shrink to almost nothing as the surge in oil prices and its effect on petrol prices together with a sharp hike in food prices pushed up the rate of inflation of goods.

The differential in the rate of increase has varied over time, as short-term effects from changes in the exchange rate or in government taxation or in government regulations have affected one series rather more than the other.

An appreciation in sterling, for instance, might be expected to dampen goods prices with little effect on the price of domestically provided services. Manufactured goods, moreover, are more exposed to international competition, much of it from so-called ‘low-cost’ suppliers.

Even with a fixed exchange rate, British manufacturers would be under much greater price pressure in the domestic market than companies in the services sectors. In contrast, regulatory effects on the utilities in the middle of the decade helped to dampen services inflation relative to goods inflation.

Nevertheless, these short-term influences apart, the price of services has consistently grown faster than the price of goods. Two explanations have been put forward to explain the divergence.

The first argument says that those sectors which are more labour intensive and, therefore, relatively more dependent on wages, have been faced with a larger increase in costs.

The reason for this is that wages tend to rise over time at a rate equal to the rate of inflation plus the increase in productivity. Wages grow in real terms. To the extent that companies have been able to pass those increased costs on to the consumer, prices will tend to rise faster than for less labour intensive companies.

The crux of this argument, however, depends on the ability of producers to pass on prices to the final consumer. One of the characteristics of the 1990s and to some extent the 2000s has been that consumers have maintained a healthy awareness of value for money. This has been partly through the lessons learned in the last recession, something which the 2008-09 recession will have reinforced.

But that awareness has also been based on the transparency which low inflation endows. Changes in relative prices are much easier to spot in a low inflation economy so allowing spending patterns to adjust quickly, making it difficult for sellers to increase prices.

It may simply be that service prices have been generally less transparent than goods prices which, combined with a preference shift away from goods to services, has allowed service providers to push prices up faster than sellers of goods.

The second argument is based on productivity growth. Sectors where productivity growth is high will be more profitable and this will encourage existing firms to expand or extra firms to enter the industry.

The end result is that supply increases relatively rapidly putting downward pressure on prices. To the extent that service industries have relatively low productivity growth, there would be less downward pressure on prices.

Stephen Nickell paper

A paper by Stephen Nickell, a member of the Monetary Policy Committee, published in January 2005, examined why the rate of inflation of goods at retail level had been so low since 1999.

He examined the movement of goods through the production process, looking separately at imported goods and those goods produced within the UK.

For imported goods, there was a significant shift through the period towards obtaining goods from cheaper sources of supply, in other words from countries able to produce those goods more cheaply.

For most of the period, the exchange rate appears to have had a neutral effect on the price of imported goods. The net effect of these two factors is that, prices of imported goods, having risen in the early part of the period being reviewed, are then estimated to have fallen from early 2002 through to 2004.

For domestically produced goods, a number of factors were seen to be operating over this period. Productivity improved sufficiently to offset wage inflation so that unit labour costs fell over the period.

On the other hand, the rising cost of business services and of raw materials and fuel put upward pressure on the cost of production.

On balance, at manufacturing level, prices of domestically produced goods are estimated to have risen in 1999 through to early 2001, then fallen through to the end of 2002 before rising again in 2003 and 2004.

Putting together all these influences plus productivity improvements in the distribution sector itself, the net result was that retail goods prices fell through the whole of the period.

This was true even of the very early period when the prices of both imported and domestically produced goods were rising. In that period, 1999 to early 2001, it was retailers, suggests Mr Nickell, who bore the pain through a squeeze on profit margins.