Column-Disinflation lesson of 2024: Ignore oil at your peril: McGeever By Reuters

By Jamie McGeever

ORLANDO, Florida (Reuters) – In today’s digital and service-dominated economy, one could be forgiven for buying into the narrative that oil no longer has any real bearing on inflation.

That would be a mistake.

Inflation is starting to exceed the targets of some central banks, largely because the annual variation in oil prices is deeply negative. This sends a clear message: oil still matters – a lot.

There is almost no corner of the economy where oil does not reach. It heats homes and businesses, powers factories and any means of transport and is a key element in the production of chemicals, plastics, materials and all kinds of goods.

True, its direct and indirect contribution to price pressure has been diluted compared to the energy-intensive economy of decades past, but oil is still one of the most accurate inflation gauges around.

And despite recent geopolitical ructions, it’s still clearly pointed in one direction.

FAKE HEAD

If investors get their oil price forecast wrong, chances are their view of inflation – and by extension, central bank policy and the broader macro landscape – will also be clouded at best and blinded at worst .

This is happening now. The past year has featured many head falsies, misleading signals and wrong calls in the financial markets, but perhaps the most important was the collective miss of the direction of oil.

In a Reuters poll of economists and analysts a year ago, the average price for 2024 and West Texas Intermediate futures was estimated to be around $86 a barrel and $83/barrel, respectively.

Brent rose above $90/bbl in April and WTI came close to that level, but oil prices have fallen sharply since then and fell below $70/bbl last month. WTI’s annual change has been negative every day since July 22 and approached -30% as recently as last week.

The effects of this on overall inflation are huge. Annual eurozone inflation is now 1.8%, below the European Central Bank’s 2% target for the first time in more than three years. As a result, ECB interest rate cut expectations have intensified considerably, even though in theory central banks should ignore energy price fluctuations.

This dynamic also dampens price pressures in the United States, where energy inflation accounts for about 7% of the consumer price index and a much larger share of the producer price index.

FED UNDERSHOOT?

Do current energy dynamics indicate that the Federal Reserve could cut rates faster than many expect? It is possible.

Analysts at Goldman Sachs forecast the contribution of energy prices to annual US CPI to rise by a tenth of a percentage point to -0.35 percentage points by April next year, pushing overall CPI up to 1.9%, below the Fed’s 2% target.

Using the current oil futures curve as a guide, April CPI inflation could slow to 1.8%.

Energy costs have more of an impact than general inflation. Even if oil prices hold steady, core inflation will still be up to 0.15 percentage points lower by the end of next year and will fall by another 0.15 percentage points if oil falls another $20/bbl , Goldman analysts believe.

On the surface, the numbers above may sound like small numbers, but in central banking every basis point counts. And these changes may still move the needle on inflation and thus accelerate the Fed’s easing cycle.

Some measures of annual monthly inflation rates are already at or below the Fed’s 2 percent target, and Fed Governor Christopher Waller recently warned that core inflation could soon follow suit.

“Consumer energy prices drag down overall inflation. With oil prices 7% lower in September … this friction should intensify in September CPI,” JP Morgan economists wrote late last month.

Now, a geopolitical or economic shock could obviously disrupt that narrative. But for now, it’s reasonable to assume that weak oil price dynamics could send central banks back to their pre-pandemic playbooks sooner than anyone thought.

(The opinions expressed here are those of the author, a Reuters columnist.)

(By Jamie McGeever; Editing by Kirsten Donovan)