11 January 2018, 17:57 GMT
The price of oil rose by around 50% over the final six months of 2017, driven by strong global growth and supply disruptions. While supply disruptions are short term in nature, strong growth, particularly if China maintains its growth, could see the global economy entering a more traditional ‘overheat’ phase in 2018.
The outlook for oil could prove an important part of this overheat phase. If oil prices reach $70 and are sustained, there could be a meaningful impact on broader materials prices and inflation expectations. Developed markets could see a rise in headline inflation of around 30-50 basis points (bps) (chart 2), alongside other factors also pushing the headline figure higher.
In this scenario, by the end of the 2018, headline inflation would exceed most central bank targets by up to 1%. The already troubled UK would probably not see the fall in inflation that most analysts are expecting, keeping pressure on consumers and the Bank of England at an unwelcome time.
This potential rise in inflation is interesting for two reasons. Firstly, 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 chart 2, which shows headline inflation, to the impact on the left hand side showing core inflation. Most people have been expecting the opposite; for 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.
Secondly, central banks would be unlikely to look through this sort of 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. Central banks 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 as well. Interest rates could therefore rise faster than many anticipate, with negative implications for certain bond prices and other rate-sensitive assets.
In the short term, the likelihood of oil reaching $70 a barrel is reasonably high. Indeed, with shrinking inventories, any supply disruption can provoke sharp price gains, seen most recently with the Kurdish-Iraq dispute, Libyan pipeline attacks and even the shutdown of the Forties pipeline in the UK.
However, the chances of the oil price remaining at $70 for a sustained period of time seem more remote, given that higher prices will incentivise US shale producers to pump more oil, as well as OPEC members facing budgetary pressures. But if global growth remains buoyant and oil prices do manage to stay at $70, there is a risk that commodity-driven inflation could end up being the year’s big story, making 2018 the year we finally enter a ‘traditional’ late cycle overheat stage.