What is the correlation between oil prices and inflation?

Outlook

We get some fresh news today (Philly Fed, leading indicators) but given the boat still rocking from the Fed statement yesterday, the Fed will continue to be the top story. As noted above, the Fed is talking about tapering and has voted for the first hike to come a year earlier in 2023 instead of 2024. Another item is the 5 bp increase in interest on reserves, including reverse repos. We expect learned discussion on whether this is a tightening signal or just housekeeping. At a guess, it won’t satisfy critics who see vast quantities of cash sloshing around the economy wreaking havoc on prudence. Not being mentioned just yet is whether the Fed will change the amounts or ratios of bonds and mortgage-backeds.

We will also get comparisons of the Fed with other central banks. The Bank of England meets next week and some wonder if the falling pound is viewed as a benefit or a drawback. Recent trade figures indicate it’s a benefit, and levels under $1.40 as we see now might be viewed as more of the same. At the same time, yields have already risen a bit much, 316% y/y (if only 0.828%). We keep being surprised at the resilience of the pound in the face of heavy Brexit headwinds; the vaccination success story can’t account for all of it.

The Swiss National Bank also met and kept the benchmark rate at -75 bp while adjusting expected inflation higher to 1% this year, but transitory and falling back to 0.6% over the next two years. A same deeply negative rate in the face of expected higher inflation is not something central banks tend to do. The dollar/Swiss franc finally gave in and we have a buy signal for the first time in donkey’s years, although to be fair, it made the breakout on the Fed, not the SNB.

Bottom line, we have central banks exiting emergency policies in this order–Norway, Canada, New Zealand, Australia, UK, US and finally Europe. But note that a fly in this ointment is the flexibility in the ECB’s bond-buying program, unlike the US’ fixed monthly amounts. It can surprise. Notice Japan is not on the list.

Finally, the news today includes the usual Thursday jobless claims, expected to drop to 360,000 from 376,000 the week before (WSJ). This will be a pandemic low and a far cry from over 6 million in April 2020, although still higher than the 2019 weekly average of 218,000.

“The steady recent decline in jobless claims is bringing weekly totals closer to what would indicate a more typical labor market. The long-term average of initial jobless claims dating back to 1967–including periods of expansion and recession–is 371,763, according to Labor Department data. The four-week moving average for the week ended June 5 was 402,500.”

All the same, we have the puzzle of the number of benefit claimants in the end-May week at 3.5 million, more than double the 2019 level. Including all the federal special pandemic programs, continuing claims were 15.3 million in the week ended May 22. Clearly there is something amiss in the data.

Bottom line, market chatter had it that the date of the first hike would get moved up from 2024 to 2023, but apparently it was not sufficiently subscribed to for the expectation to get priced in. Instead the new dot-plot was a Surprise and very nearly a Shock. Still being digested is that some members see two hikes instead of just one. This is a case of the Fed adapting to the curve instead of coming under fire for being behind it, although the Fed would never see itself as “giving in” to the market. It also doesn’t see itself as “hawkish” and we agree with rejecting that word. And there are still obstacles to overcome, including especially the next jobs report. While we await confirmation of the robustness of the recovery, the dollar is back on track to gain on the reflation trade concept. If the universe were fair, also gaining would be the CAD, AUD and NZD, who are going to be the leaders in the wind-down of emergency measures (but we can’t count on it).

Tidbit: The US is about to get a new national holiday, June 19, to mark the date the last state (Texas) heard about emancipation. The Senate passed the bill unanimously but the House had 14 (white, male) Republicans who disapproved celebrating the end of slavery. It passed the House anyway, of course. Pres Biden will likely sign the bill into law right away, with this year’s June 19 coming up this weekend.

Inflating Oil Prices: The financial press is full of stories about oil possibly reaching $100 again as the industry slows investment dramatically to re-direct it to green alternatives, which won’t come in time.

Earlier this week the FT reported “Executives from Vitol, Glencore and Trafigura and Goldman Sachs said on Tuesday that $100 crude was a real possibility, with prices already reaching their highest level in two years this week as Brent crude moved above $73 a barrel.”

The recent WTI low was $16.94 from April 2020, but it was short-lived and back to $48.52 by year-end, and has just climbed on a one-way street since then. The Goldman Sachs analyst told the FT “If you’re cutting supply without at the same time addressing your demand that is when you can get price dislocations. You’re really only one or two events away from a material spike in oil prices.”

“Oil has not traded above $100 a barrel since 2014, when a surge in supplies from the US shale sector brought the last so-called supercycle to an end. At the start of this century oil prices rallied from near $10 a barrel to reach above $100 in 2008, boosted by growing Chinese demand. Prices, while volatile, averaged around $100 a barrel for the next six years.”

On the other hand, Opec and Russia have been withholding supplies, so there is some to spare. Still, we won’t reach peak demand until 2030 and then a levelling off. Bloomberg forecasts that the green agenda will push oil into structural decline from 2035.

What is the correlation between oil prices and inflation? It was a more solid one in the 1970’s when we had embargoes, but the relationship weakened a bit by the turn of the century. It’s still there, and has toxic potential, largely due to its “multiplier effect”–oil end energy costs generally fan out in all directions. Oil prices hit the PPI before they hit the CPI, but it takes a recessionary crisis to reverse prices and inflation expectations.

Last fall the Dallas Fed rebutted a paper showing the conventional wisdom about the correlation as mistaken, finding that a rise in gasoline prices does indeed influence consumers’ inflation expectations. “The potential importance of gasoline price shocks is best illustrated by the episode from January 2009 to March 2013, when the U.S. economy recovered from the financial crisis. Inflation expectations during this episode increased by 1.5 percentage points (on an annualized basis). Chart 3 shows that in the absence of nominal gasoline price shocks, household inflation expectations would have cumulatively increased by only 0.1 percentage points. In other words, the observed increase in inflation expectations during this episode is almost entirely explained by gasoline price shocks.

Yesterday Fed chief Powell alluded to the expectations aspect of inflation, saying that if expectations start flying because of commodity prices or anything else, the Fed will take note and respond if necessary.

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