The global benchmark price of oil fell below its year-ago level on Wednesday for the first time in almost two years, a significant marker that intensifies scrutiny on the Federal Reserve’s persistently hawkish stance on inflation.
The year-on-year flip in Brent crude follows similar price shifts recently in energy and commodities such as natural gas, copper and wheat.
Against a backdrop of slowing economic activity and demand, these “base effects” strongly suggest broader inflation has peaked and could fall rapidly in the coming months.
Yet the Fed is showing little sign of backing down. Policy makers are more concerned with what they perceive to be sticky inflation in services and a tight labour market than the increasing risk of recession.
It might be a difficult line to tread for much longer if deflation in key areas like energy and commodities persists and quickly drags broader consumer price inflation back down toward the Fed’s 2 per cent target.
Gregory Daco, chief economist at EY-Parthenon, reckons that these disinflationary dynamics will intensify, so much so that headline U.S. consumer price inflation may fall below 2 per cent by the end of this year.
“Policy makers will continue to maintain a hawkish tone but it will become difficult to carve out a narrative. It’s a reflection of the fact that the Fed’s inflation-fighting tools are blunt ones,” Mr. Daco said, referring to the federal funds rate.
Minutes of the Fed’s December policy meeting published on Wednesday showed that policy makers want “flexibility and optionality” in future tightening moves.
But they stressed this should not be seen as a sign that their inflation-fighting commitment is waning, and the minutes also showed that not one policy maker anticipates lowering rates this year.
A lot can change in a year though. It is worth remembering that in December, 2021, the Fed’s median “dot plot” estimates pointed to a fed funds rate of 0.9 per cent at end-2022 and 1.6 per cent at end-2023.
War in Ukraine and global supply bottlenecks ensured inflation was far from transitory and U.S. interest rates ended last year above 4 per cent. According to several policy makers and current market pricing, they are expected to reach at least 5 per cent this year.
Annual U.S. consumer price inflation has declined five months in a row, to 7.1 per cent in November from a 40-year peak of 9.1 per cent in June, and most economists expect it to fall further.
Oil’s dynamics will help determine how quickly that fall is. EY-Parthenon’s Mr. Daco estimates that every $10 move in oil is worth around 0.2 percentage points to annual inflation.
Brent oil is below US$80 a barrel, and on Wednesday its year-on-year price differential turned negative for the first time in two years. This trend is likely to continue due to base effects – Brent hit a 14-year peak around US$130/bbl last March and was above US$100/bbl as recently as July.
Base effects in other key energy and commodity prices are pointing in the same direction, to varying degrees.
The year-on-year change in U.S.-traded WTI oil futures has sporadically turned negative since November, U.S.-traded natural gas has done so only fleetingly but its 14-year price high was not hit until August, and copper has been negative since April.
Commodity and energy costs have a notable weight in the consumer price index. According to the Pew Research Center, transportation commodities excluding motor fuel is around 8 per cent, and energy is 7.5 per cent.
Danny Blanchflower, professor of economics at Dartmouth College and a former Bank of England policy maker, says the most compelling base effect argument for comes from official inflation figures themselves.
According to the Bureau of Labor Statistics, the non-seasonally adjusted average monthly rate of consumer price inflation in the first half of last year was 1 per cent. In the following five months, that collapsed to an average 0.1 per cent.
If the annual rate of inflation is broadly the sum of 12 monthly rates, the historically high rises in the first half of last year are about to fall out of upcoming calculations.
“Base effects are now plummeting. It’s not unreasonable to think that, on base effects alone, inflation will be below 2 per cent by June,” he said, adding that bouts of high inflation are always followed by disinflation if not outright deflation.
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