The 2024 Disinflation Lesson: Ignore Oil at Your Peril – McGeever, Reuters

By Jamie McGeever

ORLANDO, Florida – In today’s economy, heavily influenced by digital services, it might be easy to overlook the significant role that oil plays in inflation. However, dismissing oil’s impact would be a mistake.

Recently, inflation levels have dipped below targets set by some central banks, largely due to a notable year-on-year decline in oil prices. This development underscores the persistent importance of oil in the economic landscape.

Oil has a far-reaching impact across various sectors. It heats homes, powers transportation and manufacturing, and is essential for producing chemicals, plastics, and numerous goods. While its direct influence on price pressures may have diminished compared to previous decades, oil remains a key indicator of inflation trends.

Currently, oil prices are crucial for understanding broader economic conditions. Investors whose forecasts on oil prices are incorrect risk misjudging inflation and, consequently, the policies of central banks.

In the past year, financial markets have experienced several misleading signals, with the misreading of oil’s trajectory being particularly significant. A poll of economists and analysts conducted a year ago anticipated 2024 prices for Brent and West Texas Intermediate crude in the range of $86 and $83 per barrel, respectively. However, after peaking above $90 in April, oil prices have sharply declined, falling below $70 per barrel as of last month, with WTI prices showing a year-on-year decrease approaching 30%.

The impact of these oil price changes on overall inflation is substantial. For example, annual inflation in the eurozone has fallen to 1.8%, dipping below the European Central Bank’s 2% target for the first time in over three years. This has intensified expectations for interest rate cuts from the ECB, despite central banks typically aiming to disregard fluctuations in energy prices.

In the United States, easing energy inflation is also contributing to lower overall price pressures, as energy prices constitute approximately 7% of the consumer price index and even more of the producer price index.

Could the current energy dynamics lead the Federal Reserve to lower interest rates more swiftly than anticipated? Analysts suggest that this is a possibility. Estimates indicate that the energy price contribution to the annual U.S. consumer price index could drop to -0.35 percentage points by April next year, pulling the headline CPI down to as low as 1.9%, below the Fed’s 2% target. If oil prices remain as they are, the CPI could further decline to 1.8% in April.

Moreover, energy costs influence more than just headline inflation; they also affect core inflation significantly. Even if oil prices stabilize, estimates predict core inflation could be approximately 0.15 percentage points lower by the end of next year, with an additional decrease if oil falls by another $20 per barrel. Although these percentages may seem minor, every basis point is critical in central banking and can alter inflation trajectories, potentially accelerating the Federal Reserve’s easing cycle.

Current measures of monthly annualized inflation rates are already at or below the Fed’s target. Recently, Fed Governor Christopher Waller cautioned that core inflation might soon follow suit as consumer energy prices continue to depress headline inflation, particularly with oil prices dropping by another 7% in September.

A geopolitical or economic shock could obviously disrupt this trend, but the current outlook suggests that weak oil price dynamics could lead central banks to return to their pre-pandemic strategies sooner than anticipated.

(All opinions expressed are those of the author.)

(Edited by Kirsten Donovan)