Oil prices are contributing to higher inflation. Could they push central banks into more rate rises?
- Recent wins on inflation could be reversed if the oil price remains persistently high
- There appears to be no immediate end to the supply/demand imbalance in the oil price
- Higher oil prices have already pushed up US CPI and may start to filter through to UK and Eurozone figures
Oil prices surged from June to September and while they have dropped slightly since the start of the month, they promise to create a significant headache for central banks. Energy costs are a meaningful share of the inflation basket and recent wins on inflation could be reversed if the price remains persistently high. With that in mind, is the current strength likely to last? And, to what extent might investors have to revise their expectations on interest rates as a result?
The working theory for the surge in oil prices is that it is a response to OPEC’s cut in oil production earlier this year. In September, Russia and Saudi Arabia extended these curbs under the year end. This has collided with rising demand. The US economy continues to experience strong growth, pushing demand higher, while Chinese demand is also strengthening. There is also incremental demand emerging from some of the larger emerging markets as their economies recover. Strategic petroleum reserves are running low.
There appears to be no immediate end to this imbalance. Saudi Arabia is trying to diversify its economy and needs high oil prices to achieve its goals, while Russia will seek to keep prices high for strategic reasons. Until some fragility emerges in the global economy, it is difficult to see any immediate drop in prices.
This is likely to weigh on inflation figures. It has already been seen in the US CPI and may start to filter through to UK and Eurozone figures over the next few months. The good news is that central banks may ‘look through’ inflationary pressures from oil price rises, having shown themselves to be more concerned on core inflation. However, it makes it very difficult to cut rates. This dashes hopes of a tailwind from falling rates next year.
In Europe, higher oil prices need to be set against an already weakening economy. They represent another cost for businesses and consumers and could dampen economic growth further. It is a similar picture in the UK, where the economy is sagging in response to higher interest rates. This could tip the country into recession.
It is not clear whether oil prices have been a significant factor in the recent rise in bond yields. Certainly, they feed into the ‘higher for longer’ narrative and make it increasingly difficult for central banks to drop rates. It is a key risk factor for investors to watch.
