When we talk about high oil prices causing inflation, we are usually referring to prices at the pump. But it turns out grocery costs are tied to the price of crude, too. As are dinners out, hotel rates, furniture and clothing costs – and many things we don’t usually think of as being associated with demand for oil.
That makes inflation-fighting, along with climate and energy policy, much more complicated.
This week, Statistics Canada reported the overall inflation rate has slowed, thanks to a decrease in the cost of gasoline, but that food prices are rising at their fastest rate since 1981. Grocery bills, up nearly 11 per cent in the past year, are higher because of “multiple factors, including extreme weather, higher input costs, Russia’s invasion of Ukraine, and supply chain disruptions.”
It turns out oil is the very important input cost. University of Calgary economists Trevor Tombe and Yu Chen have examined the “large and abrupt increase” to oil prices in 2021 and 2022 in a new paper, finding that one-quarter of non-energy items within the consumer price index are sensitive to oil prices.
“These include air transport, restaurant meals, most food categories, hotels, various durable goods and so on. We estimate that items sensitive to oil prices accounted for nearly 60 per cent of Canada’s July non-energy inflation.”
The knowledge that high energy prices affect more than just the cost of gasoline and diesel is not new. But Prof. Tombe and Prof. Chen’s research – still to be peer-reviewed – helps to quantify how significant oil is.
Why is it important? The Bank of Canada aims to keep inflation at about 2 per cent to head off the worst economic and societal effects of rapidly rising prices of everything. And if supply-side drivers of price increases are the dominant contributor to inflation – rather than demand – it’s a much trickier beast to tame.
“The source of inflation matters for how fast the central bank can bring it down and how likely they are to achieve a ‘soft landing’ of the economy,” the University of Calgary paper said.
It points out that demand-driven inflation responds to rising interest rates, but that monetary policy “does not ‘solve’ inflation arising from supply shocks such as oil production disruption, supply chain bottlenecks, or disappointing crop harvests.”
It’s no secret that the Bank of Canada and other central banks underestimated the size of the inflation wave coming this year, and held off on raising interest rates until March. The central bank was still worried about the fragility of the pandemic-battered economy, wanted to stick to its long-term plan and didn’t foresee how house prices would skyrocket in an era of ultra-low interest rates.
But the lesser known story is the bank’s more significant forecasting error. The main reason for its inflation surprise this year is because it misjudged what was coming in terms of energy prices. “Commodity price effects alone account for over 40 per cent of the bank’s total underprediction of inflation,” the bank wrote in its reflective July monetary report.
From where I sit in Calgary – a place where the machinations of the global oil industry are closely monitored – energy watchers were warning more than a year ago that a pandemic-ravaged world was starting to wake up and move, and global petroleum demand was rising faster than supplies. In the United States, companies weren’t drilling, and there was lagging OPEC production.
One of the reasons central banks in Canada, and perhaps other countries, failed to act more quickly to tame inflation is that they weren’t listening to these voices. Oil prices reached seven-year-highs in November, 2021 – well before Russia invaded Ukraine. I have to wonder, is it because some climate-focused policy makers didn’t want to listen to the knowledgeable voices who pay close attention to oil markets – but who tend to have a stake in fossil fuel production?
When the Bank of Canada reflects on why oil prices are higher than they believed they would be, they say “refinery margins recently deviated unexpectedly from their historical levels, leading to higher gasoline prices.” True. “And the Russian invasion of Ukraine has driven prices for oil and natural gas even higher.” Also true. But these explanations are far from the whole picture – which also includes that there was and could still be an absolute shortage of supply.
Prices have dropped from highs early in the summer – and oil prices plummeted further Friday based on recession fears. Rising interest rates will continue to squeeze economies, dampening demand for everything. At the same time, inflation continues to run high, energy prices could again rise, and policy makers are scrambling for solutions.
Increasing the cost of borrowing on a debt-laden public is one of the unappealing levers available to central banks for fighting inflation. In an era where climate action is an imperative, governments creating policies to address higher energy costs is even more politically fraught.
The federal NDP is calling for a windfall tax for oil companies, in the same vein as the European Union (Britain now seems to be backing away from this plan), where energy shortages mean that prices have spiked to unimaginably high levels. But if the Liberals followed the NDP’s advice here, it could further stunt investment and lead to greater political instability. The province’s Energy Minister, Sonya Savage, has said if Canada were to take similar steps, it would be considered an “extreme act of aggression” against provincial constitutional authority.
Conservatives are calling on the federal Liberals to hold off on an increase to the carbon price coming this January. While expedient, it’s difficult to imagine the federal Liberals moving away from a key climate pledge, even temporarily. Conservatives, and a few Liberals, also talk about increasing absolute supplies, and would like to see Canada produce more oil and natural gas – especially palatable if there’s a way to abate emissions.
Conservative Leader Pierre Poilievre has also talked about securing domestic supplies for all of Canada and stopping foreign imports within five years – an idea divorced from the current reality where the ebb and flow of oil markets are based on price and proximity to refineries, and existing North American pipeline infrastructure that flows mostly north and south, not west to east.
In the end, Canada’s solution will likely be some muddled path between the sides. Conservation measures and more direct aid to low-income Canadians are likely this winter.
But if there’s one lesson that comes out of the inflation and price instability of the past year, it’s that keeping a close eye on global demand for commodities – the price of grain, aluminum, minerals, natural gas and yes, even oil – is still our reality.