By John Kemp
LONDON, Nov 3 (Reuters) – Past changes in oil prices are closely associated with U.S. consumers’ and investors’ expectations for overall inflation in future, which helps explain why they are sensitive for central banks and other policymakers.
In the last three decades, the rise and fall in oil prices has correlated with expectations about future inflation measured by the University of Michigan’s monthly consumer survey and breakeven rates derived from U.S. Treasury Inflation Protected Securities (TIPS).
Cyclical changes in Brent prices over the previous 12 months have a pronounced association with changes in the expected rate of all-items inflation over the next 12 months in the University of Michigan survey.
Price changes also have a pronounced association with changes in the expected rate of all-items inflation over the next five and ten years evident in U.S. Treasury breakeven rates.
The price of oil and by extension gasoline and diesel is one of the most prominent and high-frequency prices experienced by most consumers and investors, which could explain why they correlate with expected inflation.
Consumers base their expectations of future inflation, in part, on their recent experience of actual price increases, with fuel prices playing a disproportionately prominent role.
But oil prices and expected inflation probably also both respond to common factors, most importantly the state of the business cycle (https://tmsnrt.rs/3wbvs2S).
In policymaking circles, there is an active debate about whether consumers’ and investors’ inflation expectations are relevant for setting interest rates and other elements of economic policy.
“Economists and economic policymakers believe that households’ and firms’ expectations of future inflation are a key determinant of actual inflation” Federal Reserve economist Jeremy Rudd wrote recently in a research paper.
But he concluded “a review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations” (“Why do we think that inflation expectations matter for inflation?”, Rudd, 2021).
Nonetheless, to the extent policymakers take inflation expectations into account, the association with oil prices ensures they are a matter of concern for senior officials.
In the last three months, front-month Brent futures prices have been roughly double what they were in the same period last year, with prices increasing at the fastest rate for two decades.
At the same time, U.S. consumers’ expectations for inflation over the year ahead have almost doubled to 4.8% compared with 2.6% this time last year.
And investors’ expectations for the average inflation rate over the next five years have increased to 2.9% compared with 1.6%.
Rising prices for oil and other forms of energy such as coal, gas and electricity are part of a broader pattern of price increases that is pushing up the cost of living for households and input prices for businesses.
The Fed has characterised these price rises as “transient”, a one-off adjustment to the price level, as the economy recovers from the pandemic-driven recession last year, rather than an ongoing inflationary increase in prices.
Nonetheless, the escalating price of oil has become an increasing source of concern for policymakers at the White House, the U.S. Treasury and the Fed itself.
Rising oil prices are also making real interest rates, based in part on expected inflation, increasingly negative, which is making monetary policy more stimulative, potentially worsening the instability in the business cycle.
Senior White House officials have begun to press their counterparts in Saudi Arabia for faster increases in production to help stabilise or reduce prices and indirectly to control inflation.
If oil prices stop climbing, or at least start rising more slowly, it will filter through into slower inflation and lower inflation expectations, which would comfort policymakers as well as investors, businesses and households.
If they do not, both realised and expected inflation are likely to accelerate further, increasing the probability that central banks will have to start boosting interest rates earlier and further than planned and increasing the probability of a mid-cycle slowdown if not a premature end to the current expansion.