11 May 2018, 14:54 GMT
Overheating global economy
Oil prices (WTI) are now close to $71/72 a barrel - their strongest level in three years - and if prices remain elevated, the global economy could enter a more traditional ‘overheat’ phase where inflation rises.
Central banks would be unlikely to look through this pick-up in inflation and would become increasingly confident in raising interest rates - unless growth slows more meaningfully.
The price of oil has risen by around 50 per cent over the past year, with strong global demand helping to drain the supply glut created by US shale oil. Following President Trump’s decision to withdraw from the Iran agreement on 8 May and reinstate economic sanctions, Brent crude prices reached their highest level since 2014.
Although the implementation of US sanctions will be gradual, and UK, France, Germany, China and Russia remain supportive of the existing deal, the consensus is that this could lower the supply of oil by around 300,000 to 500,000 barrels per day, or about 0.3 to 0.5 per cent of global supply.
While markets are focused on Iran and the implications for oil at the moment, they could be overlooking the more fundamental story for oil. Strong growth, particularly if China holds up, could see the global economy entering a more traditional ‘overheat’ phase of the cycle. The outlook for oil could prove an important part of this overheat phase. If oil prices reach $75 and are sustained, there could be a meaningful impact on broader materials prices and inflation expectations.
Headline inflation could rise ahead of core inflation
This potential rise in inflation is interesting for two reasons.
To begin with, such a rise in headline inflation would come before a meaningful pick-up in core inflation. This can be seen from the bigger impact oil prices have on the right hand side of the chart, which shows headline inflation, to the impact on the left hand side showing core inflation. Most people have been expecting core inflation to rise first as tighter labour markets push up wages. But this sort of inflation pressure has been notoriously absent in recent years. So we may well get the long-awaited pick-up in inflation, but not in the way we imagined.
Central banks would be unlikely to look through such a commodity-driven inflation overshoot. Commodities like oil are flexibly-priced, demand-sensitive goods, and so a rise in the price of those goods signals rising inflationary pressures which central bankers need to lean against.
Higher headline inflation would also feed into higher wages and higher core inflation. They reacted to an undershoot in headline inflation from 2014-2016, taking it as an ominous and potentially persistent signal for broader conditions, so you would logically expect them to react to an overshoot too. Interest rates could therefore rise faster than many anticipate, with negative implications for certain bond prices and other rate-sensitive assets.
Tax on growth
In the short term, the likelihood of oil reaching $75 a barrel is reasonably high. Indeed, with shrinking inventories, any supply disruption can provoke sharp price gains.
Higher oil prices will incentivise US share producers to pump more oil, as well as OPEC members facing budgetary pressures. But in the absence of a global slowdown, perhaps driven by China, commodity-driven inflation could be the next big story in 2018 as we finally enter a traditional late-cycle overheat.
However, there is an alternative explanation. Oil prices could be a sign of something more sinister. If the latest price rises are purely supply-driven, with global activity in fact peaking, then oil will become an increasing tax on growth. It will tighten global financial conditions, in addition to what the Federal Reserve is already engineering. This would lead to a more worrying mix for global markets and economies.
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