How do oil prices factor into inflation?

Oil prices play a significant role in the global economy, with its impact reaching far beyond the energy sector. Fluctuations in oil prices can have a profound effect on inflation rates, influencing consumer prices and economic growth. Understanding the relationship between oil prices and inflation is crucial for policymakers, investors, and consumers alike.

As oil prices have a direct influence on transportation costs and energy prices, changes in oil prices can quickly filter into other sectors of the economy. When oil prices rise, transportation costs increase, leading to higher prices for goods and services. This spillover effect is known as cost-push inflation.

For example, if the price of oil rises, the cost of transporting goods from one location to another increases. This results in higher prices for the end consumer, as businesses pass on the additional costs. Similarly, higher energy prices can impact households, leading to increased expenses for heating, electricity, and other essential services.

In addition to cost-push inflation, oil prices can also affect demand-pull inflation. When oil prices decline, consumers may benefit from lower prices at the gas pump, freeing up additional disposable income for other goods and services. This increase in consumer spending can lead to an overall rise in prices as demand outpaces supply.

The Current State of Oil Price Dynamics

The price of oil is determined by numerous factors, including supply and demand dynamics, geopolitical events, weather conditions, and government policies. The most widely recognized benchmark for oil prices is Brent crude and West Texas Intermediate (WTI). These benchmarks represent the global and U.S. oil markets, respectively.    Prices have been in the low $90s on these benchmarks.

However, we should also keep in mind prices outside of these two benchmarks.  A recent article by Javier Blas in Bloomberg looked at how demand from American and European customers looking for alternative sources for Russian oil have resulted in Saudi oil at $100.  The fact that Saudi Arabia accounts for 10% of oil supply means that oil prices have already hit $100 for buyers.

In recent years, the price of crude oil has experienced significant volatility. From the highs of 2014, where prices exceeded $100 per barrel, to the lows of 2020, when prices briefly turned negative due to oversupply and a demand shock caused by the COVID-19 pandemic, the oil market has witnessed dramatic swings.  When oil goes over $100 it has fallen back at some point.  In  2008 for example, it reached almost $140 per barrel of oil, but then fell dramatically afterwards to the $40s due to the financial crisis.

Looking at the oil futures market the front contract is high but longer-dated contracts are lower.  Considering the current tightness of interest rate policy worldwide and expected recession in the US during the fourth quarter this year or early 2024, we see demand falling.  In addition, we are more negative on China than the market, thus only India is left to hold up demand in Asia.  Thus, we see demand falling in the medium term.

On the supply side, the Opec+ (Opec countries plus Russia) price agreement will not work over time since countries will cheat and increase production over their quotas.  Therefore, we see an uptick in supply over time which does not bode well for oil prices.  Additionally, oil inventories are high (for example in China) and what will happen to price if these inventories are used?

The Important Question:  How will this affect Monetary Policy?

Inflation will go up due higher energy prices.  For monetary policy this is not good and will result in higher interest rates for longer.  Of course, higher prices should help central banks like the FED or ECB since it will slow down consumption and the economy.  But we see the risk to inflation playing a bigger role.

This makes it more difficult for central banks and means a hold or even more rate hikes to tame inflation.

The key risk on the minds on monetary policy makers that higher oil prices will also lead to stagflation which is inflation with lower growth.