Will Oil Price Hikes Revive The Inflation Beast?

No matter how much we would want it to be otherwise, more than 80% of the energy used by the world economy takes the form of fossil fuels like oil, coal, and natural gas. It wasn’t at the time of Russia’s incursion into Ukraine in 2022 that these commodities’ prices started rising. On the eve of the invasion, the cost of a basket of commodities was already up over 50% from a year before.

Spotlight Desk

Updated on: 11 October 2023 11:17 am

Will Oil Price Hikes Revive the Inflation Beast

When the conflict began, and oil prices spiked to $100 a barrel, economists were quick to realise the potential threat on the inflation front. They noted this together with the hindrances to economic growth that might be on the cards. Somewhat alarmingly, JP Morgan Chase & Co. warned at the time that, in the event oil prices would top $150 a barrel, the global economy might be brought to a virtual halt and inflation could fly up beyond 7%.

Indeed, in March 2022, at the time when oil prices were at a decade-long peak, inflation got a kickstart and rose to its highest in forty years. The reason for the dynamic is that, when oil prices go up , it costs companies more to buy the stuff when they need it for their products. To maintain their revenues, they tend to pass the extra cost onto consumers, where it’s felt in the form of distress in grocery store aisles. Oil is an ingredient in many of the plastic products we encounter every day. And there’s the cost of transporting all that fruit to the store, which just went up. Somebody has to pay for it, and it’s probably you.

Back in that historic March, Federal Reserve Chairman Jerome Powell told us quite plainly that inflation would rise 0.2% for every $10 per barrel hike in oil prices. By late September this year, however, oil prices had rallied by over 30% since June, driven up by OPEC+ supply cuts and the relentless US economy. Analysts couldn’t help worrying that inflation would be driven up, which could interfere with hopes the Fed will stop hiking interest rates. Were they correct?

The Fed and Oil Prices

As recently as September this year, Jerome Powell stipulated that the Fed is disinclined to react in any knee-jerk sort of fashion to hikes in energy prices, which re-assures those of us who are worried he may turn hawkish again. It’s known that fluctuations in commodity prices, even severe ones, are not out-of-the-ordinary and that they tend to right themselves soon enough. Jim Burkhard of S&P Global assures us that oil prices will settle down again pretty soon, “as demand begins to seasonally decline”.

Goldman Sachs point out that the $20-a-barrel hike in oil prices we’ve just experienced is a lot less than the $40 dollar surge back in 2008, not to mention the $45 hike in the first half of 2022. They also suggest that, since core inflation is responding nicely to the Fed’s strong medicine, it’s unlikely Powell will take up a hawkish path again in the face of all the good data.

We’re Less Oil-Sensitive

Aside from fashion, a difference between 2023 and the 1970s is that, back then, inflation and oil prices were much more strongly correlated. In our times, since the economy is less dependent on oil, its price jumps don’t push up inflation as much as they used to. Some analysts believe that this fortunate circumstance may, in fact, disappear for us in the event that fossil fuels are replaced by pricier renewable energy sources, especially if more expensive domestic supplies take the place of cheaper international oil supply chains.

The technical advancements made in shale oil drilling, which fractures underground rock holding crude oil, has lowered the quantities of oil imported by the US, while also increasing the amounts of refined oil products they export. A consequence of this is that the US economy is less vulnerable to oil price jumps. Oil price shocks may still mean we pay more at the petrol pump, but more of that money ends up going to domestic producers, softening the impact on inflation.

Moving Ahead

Besides, remember that, in the wake of Russian invasion, oil prices rose to a range between $100 and $109 for a six-month period, and that didn’t cause a recession. Ed Yardeni of Yardeni Research says that, only the type of very large oil spike that can result from a geopolitical crisis has the power to set off a recession. Of course, this may not re-assure us very much in the light of the continuing hostilities in Ukraine, and where they may potentially lead. Still, analysts point out that, if oil prices got too high, OPEC+ would likely step in and pump up the supply because a recession would not be in their interest.