From Oil Price to Core Inflation
The monetary-policy question is no longer whether energy prices enter inflation; they do. The harder question is whether they remain a relative-price shock or become broader, more persistent inflation. This chapter traces that passage through firms, households, wages, fiscal policy, and expectations, and shows how to read the evidence without treating an estimate from past shocks as a guaranteed forecast of the next one.
The First Price Increase Is Only the Beginning
When oil or gas becomes more expensive, the direct effect is easy to see. Energy costs occupy a visible place in household budgets and enter the cost of transporting, heating, and producing many goods and services. A sudden rise can therefore lift measured inflation even if spending in the rest of the economy has not become unusually strong. That first movement is economically important, but it does not by itself tell us whether inflation will continue after the energy price stabilizes.
The policy-relevant distinction is between a direct energy effect and a second-round effect. A direct effect changes the price of energy and products closely tied to it. A second-round effect occurs when the shock changes the behaviour of firms, workers, households, or governments in ways that broaden the increase. Firms may adjust prices to recover higher input costs. Workers may seek higher wages to preserve purchasing power. Households may change what they expect future prices to do, making them more attentive to increases and more likely to accept or demand higher prices. Those responses can make inflation persist even after the original commodity movement has stopped.
The process is not automatic. A firm facing a higher energy bill may absorb some of the cost through a lower margin, find a less energy-intensive input, or raise the price of its product. The choice depends on competition, demand, financing conditions, and how long the firm expects the cost to remain high. If customers are already reducing purchases, passing through the full increase may be difficult. If demand is resilient and other firms are changing prices too, the same energy shock may pass through more quickly and broadly.
The distinction also explains why a central bank should not respond mechanically to the headline contribution of energy. An interest-rate increase cannot remove the first-round scarcity. Its possible value lies in limiting the demand and expectation responses that could make the initial movement general. The decision is therefore about the propagation mechanism, not about pretending that the direct price change did not happen.
The BIS evidence suggests that the size of the initial movement changes this mechanism. Historically, large supply-driven energy price increases had disproportionately greater and longer-lasting effects on core inflation than smaller increases. “Disproportionately” is important: the estimated effect did not simply scale in a fixed ratio with the size of the shock. A very large disruption can alter pricing behaviour, household attention, and production decisions in ways that are less visible in ordinary episodes.
The estimate behind this result is specific. The BIS uses an instrumental-variable local projection to examine year-on-year core inflation after a 10% increase in energy prices. It classifies large shocks as months in which the absolute monthly log change in energy prices is above the 75th percentile. The reported responses include 90% confidence intervals. This design provides evidence that large shocks have different average consequences from the full sample; it does not provide a fixed policy threshold or establish exactly what the 2026 conflict will do.
The reason for caution is not merely statistical. Inflation can become state-dependent. A supply contraction that arrives when price-setting is calm may produce a different result from the same contraction during a period when households and firms already expect rapid increases. The BIS points to non-linearities in the inflation-output relationship observed during the 2022 inflation surge. A weaker economy does not always respond to a supply shock in a smooth, proportional way; when behaviour changes together, the pass-through can become stronger.
Inflation expectations are especially important because they connect today’s energy price to tomorrow’s decisions. If households believe the shock is temporary, they may treat it as a painful but limited change in the cost of living. If they believe high inflation will continue, they may bring purchases forward, resist nominal wage losses, or accept that firms must raise prices. Each action can be understandable on its own. Together, they can make the price path more persistent.
The BIS reports that, in its estimates, the inflation impact of an oil supply shock was more than twice as large after 12 months when inflation expectations were above target than when they were well anchored. The comparison is a warning about conditions, not a prediction that expectations will necessarily become unanchored. It is based on a 10% oil-supply shock, a particular sample, and a specified set of controls. The result says that the same physical shock can have a different inflation consequence depending on what the public already believes.
Starting Conditions Decide How Far It Travels
Expectations are not the only starting condition. The labour market can influence how quickly an energy shock moves into wages and services. When labour markets are tight, workers may press for higher wages to protect purchasing power after an energy-price increase. Firms may then face higher labour costs as well as higher energy costs. That is a plausible amplification channel, but the BIS’s reported difference between tight and slack labour markets is moderate and not statistically conclusive. The mechanism is credible; the size of the effect is not settled by this evidence.
That distinction matters for how the evidence should be used. A lack of a statistically conclusive difference in the reported sample does not prove that labour-market conditions never matter. It means the estimate does not establish a dependable difference under that design. Other conditions—such as productivity, bargaining arrangements, the ability of firms to substitute inputs, and the credibility of the inflation target—could affect whether wage claims become a lasting price impulse. The source specifically notes that the inflation effect of wage claims depends on underlying labour productivity, which is difficult to quantify in response to an energy shock and may vary across countries.
Fiscal policy can change the path in two directions, and the instruments should not be lumped together. Energy subsidies can protect households from the full immediate price increase, but if they support demand broadly they may add to inflation pressure. A price cap can limit the direct pass-through into consumer prices and shield households, yet it does not necessarily remove the underlying resource cost. The BIS’s broader finding is that an energy-price surge combined with a loose fiscal position tends to be followed by higher inflation, while a tighter fiscal stance dampens pass-through.
The point is not that fiscal relief is always counterproductive. Household protection and aggregate price stability are different objectives. A government may decide that reducing the immediate burden on households is worth the fiscal cost. For a central bank, however, the relevant question is how that choice changes total demand and the visibility of the energy price in measured inflation. A subsidy can reduce the price paid by a household while keeping spending power stronger than it would otherwise be. A price cap can restrain the observed price movement while leaving the supply constraint in place. Their distributional and macroeconomic effects need separate analysis.
The initial monetary stance also matters. The BIS finds that pass-through to final consumer prices tends to moderate when demand and inflation are relatively low and the starting monetary policy stance is tighter. A central bank that enters the shock with credible restraint may have more room to look through a direct movement because households and firms have less reason to expect a broad inflation process. That does not mean a tight stance makes the shock harmless. It means the same energy increase arrives in a different monetary environment.
The 2026 episode illustrates why amplifiers and dampeners must be considered together. The BIS reports that households’ inflation expectations were above central-bank targets, which increased the risk of knock-on effects. At the same time, weakening labour markets and uncertainty about firms’ labour demand associated with rapid AI adoption may have limited upward pressure. Global shortages of important commodities had not yet produced non-linear effects or substantial repricing, although depleted oil inventories could make those effects emerge in some countries. Fiscal deficits were smaller on average than before the 2022 episode, and monetary policy was tighter, reducing some pre-existing demand pressure.
This is a mixed diagnosis, not a verdict. Evidence that a particular amplification has not yet appeared is not evidence that it cannot appear later. The BIS’s language is careful: shortages had “so far” not triggered the larger effects, and inventory depletion “could” expose some economies to non-linearities. A policymaker who looks through the first energy movement must therefore monitor the conditions that would make the original judgment less safe.
Those conditions are interconnected. Above-target expectations can make households more sensitive to energy prices. A tight labour market can give workers more scope to seek compensation. Fiscal support can keep demand from weakening, while a lower initial policy rate can make that demand more responsive. Together, the channels can turn a supply shock into a broader inflation process. The reverse configuration can dampen the passage: anchored expectations, weaker demand, a tighter starting stance, and limited wage pressure can help keep the effect closer to the energy component.
Yet even this description should not be converted into a checklist with automatic scores. The channels may offset one another, and their timing may differ. Fiscal support may arrive before a monetary response. Wage negotiations may occur after the energy price has already begun to fall. Expectations can move before official inflation data reveal the broader pattern. A central bank must infer the state of the process from incomplete and lagged indicators.
For the look-through decision, core inflation is therefore a useful but delayed test. If it remains contained while expectations stay anchored, the case for allowing a direct energy movement to pass is stronger. If core inflation broadens, wage and price setting become more frequent, or expectations rise above target, the case for earlier action becomes stronger. Neither observation is definitive alone. Core inflation can be affected by other shocks, and expectations can move for reasons unrelated to the conflict. The value lies in how several signals fit together.
The evidence also limits what can be said about the recent event. The BIS estimates describe historical relationships and conditional responses; they do not identify a precise forecast for the current conflict. Jefferson’s speech describes the risk that a quick succession of shocks could entrench inflation and unanchor expectations, but presents that as a critical question for policymakers, not as an observed outcome. The appropriate conclusion is that second-round risks deserve attention, not that they have already materialized everywhere.
Once the pass-through mechanism is clear, the next question is why it behaves differently across economies. An energy importer may lose income and see its currency weaken when fuel prices rise; an exporter may gain income and experience appreciation. Energy intensity, subsidies, expectations, and starting policy stance can make a common shock look like a different inflation problem from one country to another.