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Thu, April 25, 2024

Oil & Central Bank Policy

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We are living in an intertwined world where one factor drives the other. In the global financial markets, the preceding line holds since one aspect directly or indirectly influences the other in the same asset class or across asset classes. In the commodity market, crude oil is one such asset; its bullish and bearish nature significantly impacts global economies. In the past few months, the rise in prices of crude oil gently pushed the headline inflation rates higher and compelled central banks around the world to revise their policies. 

In September, Russia and Saudi Arabia agreed to extend their 1.3 million barrels per day production cuts through December. Market pundits believe that this will result in a market shortage of more than 1.5 million barrels per day in the last quarter of 2023. While OPEC+ member nations have decided to review their decisions monthly, the extended cuts will boost both the Brent Oil and WTI Crude Oil markets. This will complicate things for the US Federal Reserve and other global central banks. These organizations are concerned that a gradual rise in crude oil prices could derail some of the progress they had made on inflation. In hindsight, energy prices are the nuanced aspect of inflation that central banks cannot control directly.

Correlation Between Crude Oil Prices and Inflation 

Examining the correlation between crude oil prices and inflation begins with understanding that crude oil is a fuel that drives the global economic engine. In other words, the price of oil can influence the cost of energy, transportation and production thereby affecting the prices of goods and services. This interlinking means that a hike in oil prices contributes to inflation. However, the level of influence is a topic of debate among strategists and economists. However, a significant increase in the price of crude oil may drive modifications in the policies of central banks. 

Rewinding the clock to our economics classes, let us first understand the major points of difference between cost-push and demand-pull inflation.

Cost-Push Inflation 

As per Investopedia, “Aggregate supply is the total volume of goods and services produced by an economy at a given price level. When the aggregate supply of goods and services decreases because of an increase in production costs, it results in cost-push inflation. Cost-push inflation means prices have been “pushed up” by increases in the costs of any of the four factors of production—labor, capital, land, or entrepreneurship. In order to compensate, the increase in costs is passed on to consumers, causing a rise in the general price level: inflation.” 

The rising prices of crude oil are a preview to cost-push inflation. Numerous analysts note that the percentage of a consumer’s total budget spent on energy products is only in the range of 3% to 6%. However, this is not the only place where the value of oil may influence consumer budget. High oil prices boost production costs, increasing the prices for goods and services thus increasing consumer inflation. The industries which are heavily reliant on oil such as transportation and manufacturing feel the pressure and transfer the additional costs to the consumers. 

Demand-Pull Inflation 

According to Investopedia, “Demand-pull inflation occurs when there is an increase in aggregate demand, categorized by the four sections of the macroeconomy: households, businesses, governments, and foreign buyers. When concurrent demand for output exceeds what the economy can produce, the four sectors compete to purchase a limited amount of goods and services. That means the buyers “bid prices up” again and cause inflation. This excessive demand, also referred to as “too much money chasing too few goods,” usually occurs in an expanding economy.” 

For example, as the cost to manufacture and transport a new television starts driving the price higher, consumers decide to rush out and buy one immediately before the price increases even more. This is not only relevant to the consumers. When oil-producing countries experience a windfall due to elevated oil prices, their increased purchasing power can globally fuel additional demand-pull inflation. This increase in the total demand, outpacing supply exerts upward pressure contributing to inflation and the circle continues. 

The impact of inflation can generate a global central bank response. Central banks may try to modify via higher rates, which can hurt small organizations and consumers who rely on short-term loans to drive their spending forward. A slowdown may occur when higher crude oil prices combine with higher rates. Higher energy prices for consumers may result in reduced disposable income for families, dampening their consumer spending on other goods and services. This will increase the reliance on short-term loans such as credit cards and home loans which now may be set at higher rates than before. Since consumer spending activities account for a significant portion of economic activity, a decline can affect corporate revenues and eventually stock prices. 

Conclusion 

A ray of hope was ignited as OPEC’s crude oil production climbed in August by an average of 113,000 barrels per day coupled with the news from the USA that the production surpassed 13 million barrels a day during the first week of October, the highest since March 2020. If the other oil-producing nations follow suit and demand does not spike beyond expectations, the central banks may have dodged a bullet at the growth they have made so far on inflation. 

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E-Magazine
MARCH 2024

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