By Michael Burke, B&M Research
The recent sharp rise in the oil price has been a dominant theme in financial markets, where general expectations are that this will lead to higher inflation, weaker growth and higher interest rates. The oil price has recently edged towards $28bbl, having been below $18bbl in November of last year and below $11bbl in 1999. Although the market is less convinced about the clear-cut impact of a rising oil price on the currency market, there is a perception that the increase in payments towards the oil producers will have a destabilising effect on both the major currencies and those of the oil producers.
It is difficult to overstate the importance of oil to the world economy. In monetary terms, oil accounts for around 6% of world GDP and, despite the rise of the ‘New Economy’, remains central to both the industrial and service sectors and of course to world trade.
However, it is necessary to explode one important myth in relation to the oil price, which is that a rising price of oil is the cause of inflation. Milton Friedman probably overstated the case with his dictum that ‘inflation is always and everywhere a monetary phenomenon’ but it does point up the logical hole in the argument that a rise in the price of one good (however important) can lead to generalised and persistent inflation. If the price of a cab ride goes up, we either have less to spend on other goods or services, or we take the bus more often.
This myth of the all-important role of oil grew up in the period of rising prices in the early 1970s and became entrenched after the period of high inflation in the 1980s. The period is even described as that of the ‘Oil Price Shocks’. However, it does not correspond to reality.
In the chart above, we show three variables. The first is US CPI (green line, left axis), the second is the world year-on-year change in consumer prices (red line, also left axis) and the third is the export price of the oil producing countries (yellow line, right axis). It is clear from this chart alone that rising oil prices are not the cause of rising world or US inflation, but actually lagged these inflationary pressures by some years. Towards the end of the period, inflation was able to slow markedly even though the oil price continued to rise. The 1980s are decisive, since the decade forms the genesis of the myth about oil price pressures, but it is also the case generally that the rise in the oil price has tended to lag the rise in world CPI.
Of course, given that the US CPI is in part comprised of the oil price it is inevitable that the two are correlated. The same is true of world prices, with energy prices accounting for 48% of the Goldman Sachs Commodities Index, which is consumption weighted. Even so, the fact that the oil price consistently lags the change in consumer prices completely undermines the notion that inflation is driven by rising oil prices. Instead, it is much more likely that both the CPI index and the oil price are responding, with a differential time lag, to an external shock that lifts the price of all goods. For Friedman this external shock would be an increase in money supply. It could also be a relaxation of the fiscal stance in one or more leading economies. This would have the effect of reducing the relative purchasing power of money, and so increase the price of goods.
Impact On Rates
It is well-known that bond yields usually start to rise before a rise in inflation. It is possible that this occurs either because bond market participants are accurate predictors of inflation, or more likely, because a key determinant of rising bond yields (such as increasing demand for capital either from the private or public sectors) has the subsequent effect of also pushing up inflation.
Since we have already established that rising oil prices tend to lag rising inflation, the usual sequence of events is then: bond yields rise – CPI rises – oil price rises.
However, the most recent cycle is slightly different, with bond yields once again leading the way, followed by a rising oil price and a CPI which, so far, is yet to rise. This flat inflationary trend is technically the result of a prolonged period of unchanged inflation over the last few months. More fundamentally it reflects the effects of the steep drop in capacity utilisation rates combined with unexceptional demand growth. While it is quite likely that this flat trend in the headline rate will be punctured by the oil price, the sticky downside pressures on inflation tend to suggest that structural factors are at work which will contain the upside for the CPI.
This may be decisive for the conduct of monetary policy in the current cycle. The Fed is generally successful in timing its efforts to pre-empt inflation. Of course, it is not always so successful in containing the scope of the upsurge in prices. But there are factors specific to this cycle suggesting that monetary policy has not been as effective as previously, notably the fact that the stock markets are still below their pre-easing peak. It is this type of blockage which probably caused the FOMC to consider emergency measures at its January meeting.
In a parallel trend, inflationary pressures may be blocked by a combination of factors such as excessive investment, over-capacity or even the ineffectiveness of monetary policy itself (and the negative consequences for consumer ‘wealth effects’). This may be the case currently for the PPI (itself highly correlated to the CPI), which remains in a downtrend, at least for the time being, despite the upsurge in oil prices. This too may end soon, but it would not undermine the basic idea that structural factors will prevent the rise in oil from turning into a sustained bout of inflation, with clear consequences for monetary policy and the front end of the curve.