Perspectives

Energy prices are a key wild card for inflation and growth

The optimistic consensus for peak inflation also appears consistent with consensus forecasts by oil analysts that crude oil prices have peaked as well. For example, Bloomberg’s survey of oil analysts shows the median analyst expects the price of Brent crude oil to fall from an average price in May of $112 a barrel to an average of $90 a barrel next year. Crude oil futures are a bit less optimistic, but still put the price of Brent crude at an average of about $95 per barrel, down about 15% from its recent range (Chart 2). Of course, both analysts’ forecasts and what is priced in futures markets need to be taken with a large grain of salt. The fundamental backdrop remains highly uncertain. On the one hand, further energy supply disruptions associated with the Russia-Ukraine war could easily push prices higher. On the other hand, higher interest rates, tighter financial conditions, and U.S. dollar strength have the potential to drive prices lower.

Year-ahead forecast errors of plus or minus 20% tend to be the norm when it comes to oil prices. Also, it’s worth noting that hte oil derivatives market recently has been heavily skewed toward investors protecting htemsleves against the risk of higher oil prices. That is seen in an extremely low put-to-call ratio for NYMEX West Texas  Intermediate (WTI) crude oil options, with the ratio having been lower only 1% of the time since 2010 (Chart 3). This suggests that the near-term risk to oil prices is to the upside against a highly unsettled geopolitical backdrop.

And while the price of crude oil can often be viewed as a good barometer for whether oil consumers are facing an “oil shock,” the energy situation is further complicated by very low fuel inventories and very limited spare refining capacity. That has created a near-vertical ascent in the price of fuels like diesel and unleaded gasoline, which have increased in the year to date by 55% and 42% respectively (Chart 4).

Here’s the issue, as explained by Bloomberg’s commodity expert:

“Right now, the traditional relationship between crude and refined products is broken. WTI is anchored around $100-$110 a barrel, suggesting that — in barrel terms — gasoline, diesel, and jet fuel prices shouldn’t be much higher ,once you add the average refining margin.

In reality, there are a lot more expensive. Take jet fuel: in New York harbor, a key hub, it’s changing hands at the equivalent to $275 per barrel. Diesel isn’t far away, at about $175 a barrel. And gasoline is about $155 a barrel. Those are wholesale prices, before you add taxes and marketing margins.

What’s changed? Refining margins have exploded. And that means energy inflation is far stronger than it appears.” ¹

Now consider the potential for oil demand to grow as we enter the summer driving season against a backdrop of extremely low fuel inventories. And also consider the potential for global oil demand to increase as China starts to reopen from its extreme zero-Covid lockdowns. Using these assumptions, some oil analysts believe that prices at the pump could continue to soar in coming months.² 

Higher energy prices would prompt more aggressive Fed tightening

That’s a risk, not a certainty but what would continuing upward pressure mean on energy prices mean for the Fed?

Fed Chair Jerome Powell addressed that question in a mid-May interview when he emphasized that “this is not a time for tremendously nuanced readings of inflation.” In perhaps his most hawkish comments to date, he made the following pointed comments at a Wall Street Journal live event:³

“What we need to see is inflation coming down in a clear and convincing way, and we’re going to continue to keep pushing until we see that. If that involves moving past broadly understood levels of ‘neutral,’ we won’t hesitate at all to do that.”

Former Fed Chair Ben Bernanke gave a speech in 2004 on the topic of how central banks should respond to energy shocks.⁴  This gist of his view is that the starting point of inflation and growth should determine how to respond to an oil shock. When inflation is already high, monetary policy should be views as “an investment in future economic stability.” Bernanke’s speech highlighted recessions that began in 1973 and 1981 as “unfortunate side effects” that followed Fed rate hikes aimed at containing the inflationary effects of oil shocks.

Chair Powell and many of his colleagues are borrowing from Bernanke’s playbook, making it clear that they are willing to take the risk of an economic recession resulting from tighter monetary policy. A look at previous oil price shocks, measured by periods when oil prices exceeded their long-term moving average by a wide margin, shows that recessions have tended to precede or coincide with oil price shocks (Chart 5). As Bernanke noted, tight Fed policy typically played a starring role during those recession periods.

In short, the energy shock the U.S. economy has already experienced has created near-term inflation pressures while also cutting the outlook for real economic growth. And the effect on growth trends to come through two important channels. First, higher energy prices act like a tax on consumers, draining their purchasing power and lowering their ability to spend on discretionary consumer purchases. Second, they lead to more aggressive monetary tightening by the Fed aimed at curbing the inflationary effects.

Oil shock or not, the Fed is likely to curb inflation

As we noted earlier, higher energy prices have recently been a key driver of inflation from a pure arithmetic standpoint. But that does not mean that they will continue to be a key driver of inflation from a fundamental standpoint. If energy prices go up while aggregate demand trends are under control, it simply means that some other prices need to go down.

This would be true even if there is an upward bias to energy prices in coming years due to the structural underinvestment in the energy sector related to capital discipline or the regulatory environment. If aggregate demand is well controlled, higher energy prices simply imply a change in the relative price of energy. That differs from a process of escalating prices on an economy-wide and persistent basis.

To illustrate that energy prices have not been a persistent fundamental driver of inflation, consider the trajectory of the energy component of the CPI from July 2008 to April 2022 (Chart 6). Over that long period, the energy component increased by only 10% (or 0.7% at an annual rate). In contrast, the overall CPI gained 32% (or 2.0% at an annual rate). Some components of the CPI, like durable goods prices and apparel prices, fell for most of that period while many other service prices rose by even more than the overall CPI. The relative price of energy fell versus the overall CPI during that period. So it was clear that energy prices were not the key driver of CPI inflation over the long term.⁵

We would point to monetary and fiscal policy, as controlled by the Fed and the U.S. Congress, as being far more important fundamental drivers of inflation. From that perspective, the extraordinary burst of inflation the U.S. has experienced recently can be traced to the emergency “wartime finance” monetary and fiscal policies put in place in 2020 and 2021 in response to the pandemic.

As we have discussed previously, more that $5 trillion of fiscal spending (about 25% of FDP) was authorized from March 2020 through March 2021. And most of this spending was effectively financed through comparably sized Fed purchases of U.S. Treasury securities (Chart 7). That experiment with Modern Monetary Theory (MMT) initially kept interest rates extremely low. It was also associated with a 40% increase in the U.S. M2 money supply over a two-year period, as stimulus checks, PPP loans, and other large spending initiatives were rapidly deposited into bank accounts.

With the benefit of hindsight, it perhaps should not be surprising that “wartime finance” resulted in a burst of inflation as has happened during other periods of wartime finance in the U.S. But along with an improving health situation, monetary and fiscal policy are now clearly normalizing. The budget deficit has shrunk from a peak of 18.6% of GDP in the 12 months prior to Mach 2021 to 4.9% in the latest twelve months. Moreover, the Fed has ceased buying U.S. Treasury securities and is now set to shrink its balance sheet. Broad money growth is also decelerating, with M2 growing at an annual rate of only 6.2% in the first quarter of this year after many quarters of double-digit annualized growth — following a remarkable “peak pandemic” rate of 65.3% annualized growth in the second quarter of 2020.

Regardless of near-term energy market trends, we think the normalization of U.S. monetary and fiscal  policy is likely to be the decisive factor that will curb inflation pressures in coming quarters. It remains to be seen how aggressive the Fed will need to be to bring inflation back under control, but we would not bet against either its ability or determination to do so.

William P. Sterling, Ph.D.