Early this week, the EU finally agreed to a 90% reduction in usage of Russian oil by the end of the year. The move caused a big surge in oil prices, with Brent almost hitting $120 again. Experts now predict that oil prices could continue surging throughout the year, with price targets ranging between $130 to $150 per barrel by the end of this year.
This movement in oil price is not a very welcome phenomenon, as this would mean gasoline prices would surge even higher during the summer driving season. Investors also fret at the possibility that higher oil prices may cause inflation to surge again, leaving the Fed with no choice but to raise interest rates beyond the 50 bps telegraphed for June and July.
Investors only just managed to brief a sigh of relief after April’s data revealed that inflation may have peaked, which has led the markets higher in anticipation that the Fed would pause after July. Mainly, the two key data points driving the less hawkish sentiments were:
- PCE: the Fed’s favorite measure of inflation, the Core PCE for April was 4.9% YoY vs. a reading of 5.2% YoY in March. This is the first drop in the index in 17 months. Although one reading isn’t considered a trend, looking at it in context with other inflation readings may suggest inflation has plateaued. The headline PCE reading was 6.3% YoY vs a March reading of 6.6% YoY.
- CPI: the April CPI reading was 8.3% YoY for April vs 8.5% YoY in March, while the Core CPI for April was 6.2% in April vs 6.5% in March.
The latest GDP figure release also supports the expectation of reducing inflation. The April GDP figure of -1.5% was also weaker than March’s -1.3%, showing a slowdown in the economy, resulting in less consumer spending, which will, in turn, send prices of goods and services lower.
However, have investors cheering for the worse being over for inflation considered oil prices? In April, when the inflation rate fell from March’s high, oil spent most of the time at a mean price of around $105, lower than the March average of $110.
Could the easing of inflation in April be due to a fall in oil prices then? As we move into June, oil prices are surging rapidly again to beyond $115. This behooves us to ponder, will inflation surge again and make the Fed more hawkish? To make an informed guess, let us look at the impact of oil price on the Fed's measures to gauge inflation.
The Role of Oil in the Fed’s Inflation Gauge
Fed Chair Jerome Powell said in his semi-annual testimony before the US Senate Banking Committee in March 2022 that, as a rule of thumb, every $10 per barrel increase in the price of crude oil raises inflation by 0.2% and sets back economic growth by 0.1%.
A study by the Federal Reserve Bank of Dallas in September 2021 suggested that if crude oil prices rose to $100 per barrel for three months before retreating, the spike would boost the annual inflation rate by 3 percentage points in the short term, with the effect fading quickly as oil prices pulled back.
However, the Fed uses the core personal consumption expenditures price index (core PCE) to gauge inflation, which has a far lower gasoline weighting than the CPI. In fact, according to the US Department of Commerce, the core PCE does not include food and energy.
Thus, even if oil prices were to continue surging, the Fed may not see inflation climbing because the energy complex is not included in the core PCE calculation, which the Fed uses to gauge inflation.
Won’t the Price of Oil Creep into Other Sectors?
According to the US Bureau of Labor Statistics, energy accounted for about 7.3% of the CPI as of December 2021, including the index weighting of about 4% for energy commodities. In addition to that direct effect on inflation, higher oil prices raise inflation indirectly because crude oil is a key ingredient in petrochemicals used to make plastic.
So, more expensive oil will increase the prices of many products made with plastic. Similarly, consumer prices factor in transportation costs, including fuel prices, and the cost of oil accounts for roughly half of the retail price of gasoline.
While such an indirect impact on prices of other goods included in the core PCE and core CPI will be reflected, the impact is minimal from historical data. It does influence the core PPI, and the Fed does not use core PPI as an inflation gauge.
According to the Federal Reserve Bank of St. Louis, between 1970 and 2017, the correlation between oil prices and the PPI was 0.71, while the correlation with the CPI was only 0.27, showing the effect oil prices have on the CPI is small.
Data from Federal Reserve Economic Data (FRED) also shows the low effect oil prices have on price rises of goods and services and that the core PCE is not affected by oil prices.
Hence, there is little possibility that the Fed would hike more aggressively even if oil prices were to continue surging, not even perhaps when oil surges beyond $150 per barrel. However, that does not mean our pockets will not feel the pinch since food and energy are core expenditures for every household.
A $10 gasoline will hurt every consumer out there since even public transport and electricity prices will go through the roof even if one does not drive. The consolidation is that monetary policy may not have to tighten, which would otherwise hurt our pockets even more as funding becomes more expensive.
While consumers find ways to shelter themselves from rising prices, stock market investment, gold and crypto could benefit as people try to ride the wave of rising prices. In such a scenario, their roles as inflation hedges could be amplified. Hence, as oil prices climb further, stocks, gold, and cryptocurrencies may see a rally even though economic activity may decline.