Kate Mackenzie Rising crude and inflationary expectations

Lower oil prices helped bring inflation down to zero in the Euro area in May. Bond markets have in the past couple of weeks begun to anticipate some inflation growth in the US over the next two years, and the ECB and various commentators are voicing confidence that the region will return to inflation by the end of the year, after a brief deflationary period.

What role might oil prices play in inflation rates over the next few months? It’s a question that has been concerning many market watchers in recent weeks, particularly those who worry that the very low official interest rates and quantitative easing measures being taken in the world’s biggest economies could lead to high inflation in the future; or that oil prices are not reflecting a fundamental increase in demand but rather the effect of restocking. Reuters yesterday wrote about ‘alarm’ over the inflationary effect of the oil surge, as inflation expectations returned to the bond market in the past two weeks after a prolonged absence, following the sharp rise in crude prices in the past month.

With deflationary fears easing, the Bank of England and the ECB are today both talking about exit strategies for monetary measures such as quantitative easing. But the timing will be everything, and the relationship between energy markets and inflation rates will be an important factor that could push this move earlier than markets would like.

The energy-inflation relationship

John Kemp last week picked apart the oil-inflation relationship and posted some interesting charts on the subject, using the break-even rate between conventional and inflation-protected Treasury notes as an indicator of inflation. Actual moves suggested a strong relationship, particularly while both inflation and oil prices were falling sharply late last year. But on a 60-working-day (3 months) movement basis, he says the movement is less strong:

Kemp writes that oil prices affect inflation through its use in consumer price indexing and its indirect effect on other components of the index, but he writes the causation can also work the other way around, if crude futures have a speculative component and are used to hedge against inflation – which he notes is a popular strategy.

In fact, causation probably runs in both directions. A rough working hypothesis is that oil prices are currently being driven higher by expectations of future inflation, as much as the other way around.

Factoring oil prices into inflation expectations

The fear for some is that central banks might be provoked into raising interest rates sooner than expected. As John Authers explained:

This in turn feeds into what has become the central debate between market bulls and bears; what will be the “exit strategy” for central banks? Bears, who ironically think the economy is quite strong, believe that rising inflation will force the Federal Reserve and other central banks to raise rates by the end of the year. Commodity prices are their prime evidence.

Relative bulls are confident that there is still so much slack in the world economy that deflation is the greater risk – and therefore rates will stay low, helping commodity and equity prices.

Ian Hartnett of Absolute Strategy Research points out that charting the six-month change in crude prices against headline US CPI implies the US could see inflation of 4 per cent by the end of the year:

To paraphrase John Authers in the accompanying video, this view suggests oil prices may not be being taken seriously enough. Either way, the rather sharp rise in oil prices seems set to influence inflation expectations for some time yet.

Related links:

Short View: Oil and inflation (FT, 10/06/09)