In today’s digital and services-dominated economy, one might be forgiven for buying into the narrative that oil no longer has any real bearing on inflation.
That would be a mistake.
Inflation is starting to undershoot some central banks’ targets, in large part because the year-on-year change in the oil price is deeply negative. This is sending a clear message: oil still matters – a lot.
There’s barely any corner of the economy that oil doesn’t reach. It heats homes and businesses, powers factories and every means of transport, and is a key input in the production of chemicals, plastics, materials and all manner of goods.
True, its direct and indirect contribution to price pressure has been diluted compared to the energy-intensive economy of decades gone by, but oil is still one of the most accurate inflation weather vanes around.
And, despite recent geopolitical ructions, it’s still clearly pointing in one direction.
HEAD FAKE
If investors get their oil-price forecast wrong, chances are their view of inflation – and, by extension, central-bank policy and the broader macro landscape – will also be blurred at best, and blinded at worst.
This is happening now. The past year featured many head fakes, misleading signals and wrong calls in financial markets, but perhaps the most consequential has been the collective miss on the direction of oil. In a Reuters poll of economists and analysts conducted a year ago, the average 2024 price of Brent and West Texas Intermediate futures was forecast to be around US$86 a barrel and US$83/bbl, respectively.
Brent rose above US$90/bbl in April and WTI got close to that level, but oil prices have fallen sharply since then and last month dipped below US$70/bbl. The year-on-year change in WTI has been negative every day since July 22 and approached -30 per cent as recently as last week.
The effects of this on overall inflation are huge. Annual inflation in the euro zone is now 1.8 per cent, below the European Central Bank’s 2 per cent target for the first time in more than three years. Consequently, ECB interest-rate cut expectations have intensified considerably, even though central banks are theoretically supposed to ignore energy price fluctuations.
These dynamics are also easing price pressures in the United States, where energy inflation accounts for around 7 per cent of the consumer price index and a much higher share of the producer price index.
FED UNDERSHOOT?
Are current energy dynamics signaling that the Federal Reserve could cut rates more quickly than many expect? It’s possible.
Analysts at Goldman Sachs estimate that the energy-price contribution to annual U.S. CPI will increase one-tenth of a percentage point to -0.35 percentage points by April next year, pushing headline CPI as low as 1.9 per cent, below the Fed’s 2 per cent goal.
Using the current oil-price futures curve as a guide, headline CPI inflation in April could slow to 1.8 per cent.
Energy costs impact more than just headline inflation. Even if oil prices hold steady, core inflation will still be as much as 0.15 percentage points lower by the end of next year, and will drop a further 0.15 percentage points if oil falls another $20/bbl, Goldman’s analysts reckon.
On the surface, the above figures may sound like small numbers, but in central banking every basis point matters. And these shifts can still move the needle on inflation and thus accelerate the Fed’s easing cycle.
Some measures of annualized monthly inflation rates are already at or below the Fed’s 2 per cent target, and Fed Governor Christopher Waller recently warned that core inflation could soon follow suit.
“Consumer energy prices are dragging down headline inflation. With oil prices down another 7 per cent in September ... this drag should intensify in the September CPIs,” JP Morgan economists wrote late last month.
Now, a geopolitical or economic shock could obviously disrupt this narrative. But, for now, it’s reasonable to assume that weak oil price dynamics could send central banks back to their prepandemic playbooks sooner than anyone thought.
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