Oil: From Inflation’s Friend to Foe
Inflation is one of the most difficult macroeconomic variables to forecast, as evidenced by many PhDs at the Fed and in Wall Street getting it very wrong last year. Even now, more than two years after the onset of the pandemic, it’s only gotten more difficult to prognosticate.
To put things into perspective, the dispersion today among professional forecasts of inflation is greater than it was during the Gulf War of ‘90/’91, an episode that involved major oil players as combatants, much like today’s state of affairs.
With the CPI for the month of May scheduled to be released at the end of this week, we thought it’d be relevant to our members to present our view of where we think inflation is headed over the next several months. That’s the objective of this article, where we particularly focus on the motor fuel component. We think the latter will play a pivotal role in bringing about disinflation, providing relief for the stock market. Much like shelter, motor fuel has been a big driver of the inflation dynamic post-Covid.
That should come as no surprise, because following the trough in the overall price level in May 2020, the motor fuel component of the CPI has risen by a whopping 130%. That’s the biggest rise on record over the last 50 years or so.
As a result, we believe that the extent of the move has materially cut down the runway for oil price upside and makes up a critical data point informing our view that the commodity is now poised to turn from inflation’s friend, to foe. Energy prices can be self-limiting of course, as rising costs can slow down the economy. As the old adage says, the cure for high price is high prices.
Getting the call on inflation right matters because it can inform our view on the stock market. In an event study that we ran across nearly 20 episodes involving peaks in the inflation rate going back to the ‘50s, we found that the S&P 500 generally moved higher as it climbed over the inflation wall of worry. In fact, the S&P 500 tended to bottom right before the peak in inflation was seen.
A Lot is in the Oil Price, Downside Skew
To get the call on inflation right, one needs to get the call on oil right as well. That’s become an increasingly difficult effort as the Ukraine/Russia war has brought a lot of uncertainty around the outlook for the black gold. So far this year the implied volatility around oil has risen alongside the oil price, an unusual outcome if we look at the history. All of that tells us that oil prices represent the biggest swing factor in the outlook for inflation.
Oil has long had a geopolitical character as reflected in the recent price run-up related to the conflagration between Ukraine and Russia.
We were curious to compare how the jump in the oil price of late compared with historical episodes when war also broke out. To do that we leveraged a very interesting indicator drawn from the academic world. It tracks the share of newspaper articles each month containing verbiage generally associated with the onset of wars. We focused on the month-over-month change in that index to capture the shock of the event.
The chart below puts the Ukraine/Russia war into context by comparing the shock of that event with those from the Gulf War and the Invasion of Iraq, two episodes also involving major oil suppliers as combatants.
What we found was that in this most recent conflict, the oil market well anticipated the onset of the bellicosity. That’s actually not atypical if we look at the top-10 episodes where the aforementioned war indicator saw the biggest jumps. The grey bars illustrate the change in the oil price six months prior to the onset of war. On average, those moves far exceeded the historical average if we compare the two grey bars at the bottom of the previous chart.
Moreover, within two months following the onset of war, there generally was a big pullback in the oil price, as shown by the red bars. That’s not yet happened in the Ukraine/Russia war as the uncertainty remains elevated.
When we cumulate the returns from the three bars of the prior chart (i.e., the prior six months to the conflict, month of the onset and two months post) what we found is that the jump in the oil price associated with the Ukraine/Russia war (i.e., the war shock) far exceeds what we’ve seen in prior conflicts. That’s represented by the bars in the following chart.
All of this informs our view that a hefty war premium looks imbued in today’s oil price. We can draw a similar conclusion by looking at the contribution to the change in the oil price attributed to supply shocks over the last 36 years or so using a model from the New York Fed. That’s at an extreme today as evident in the chart below.
All of this informs our view that the oil price looks vulnerable to a de-escalation of tensions, and/or economic deceleration, with big implications for the inflation outlook and the stock market.
That said, we’re humble to the idea that forecasting the oil price is a very difficult undertaking, particularly amidst the extreme circumstances. We’re not looking to derive an exact forecast of where the price of oil is headed, we’re simply assessing the runway and what that means for inflation. We’re playing the odds and we believe those favor oil prices weakening from here.
Of course, we could be wrong, and perhaps the conflict escalates and spills over onto the rest of Europe, drawing more combatants into the mix. It’s not clear what would happen in that scenario, although the invasion of Kuwait in August 1990 could serve as precedent. Back then the oil price rose materially following Iraq’s invasion of Kuwait as the U.S., U.K. and Saudi Arabia joined the Gulf War.
Inflation and Oil are Tied at the Hip
As mentioned earlier, we looked at close to 20 historical episodes over many decades when the U.S. inflation rate peaked. We were looking for insights as to the role motor fuel prices played in the disinflation process that ensued. One of the questions we were looking to answer was whether a fall in the oil price alone could be enough to bring about a weakening inflation rate from here.
What we found was that motor fuel was the biggest driver of the disinflation process. The chart below compares the average trajectory of motor fuel inflation with that of shelter as an example. If we look at the scales of the two y-axes, we’ll see that the drop in inflation off the peak was massively-bigger for motor fuel than it was for shelter.
In fact, across all of these episodes, in the 12 months that followed the peak of overall inflation, the inflation rate of the motor fuel component collapsed by an average of nearly 31 percentage points, while for shelter the drop was only about 1 percentage point.
The reason for that is that motor fuel is much more volatile than other CPI components. We can see that clearly in the chart below that compares the historical volatility of motor fuel with that of the other CPI components like shelter and new and used vehicles. Motor fuel is in a league of its own.
That volatility is a big deal because when we look at the weights of the various components that comprise the CPI in the chart below we find that motor fuel’s is small, at less than 4%. That has to do with the secular decline in energy’s share of consumer expenditure of the past 60+ years. On the other hand, shelter’s weight is around 30% of the CPI, more than 7x bigger. In other words, what motor fuel lacks in size it more than makes up in volatility.
Separately, what we also found interesting across the episodes was that, on average, inflation decelerated off the peak at lot quicker than it accelerated into it. That tells us we should be prepared for the disinflation process to evolve faster than many anticipate.
Moreover, it was telling that motor fuel disinflation was a consistent feature across all of the episodes we studied. In the case of shelter inflation, it only declined in half of the episodes. In other words, oil should play a crucial role for inflation edging lower from here, and we don’t need a collapse in rents (i.e., shelter) for disinflation to come about.
Not Calling for a Careening Fall in the Oil Price
We want to make an important distinction here. Although we expect weakness in the oil price in the months ahead, we’re not calling for a collapse, as that’s not what our research is telling us. While the global economy is showing signs of deceleration, we think today’s setup is vastly different from what we witnessed in 2008. Back then the oil price swooned 70% only a few months following the peak that summer, as the world stepped into the abyss of the Financial Crisis that led to a deflationary episode. Back then the consumer had levered up into a housing cycle bust. We don’t see evidence of that today, as shown in the chart below.
Those types of credit booms are generally associated with significant economic downturns, as depicted below. Disinflation, not deflation, is our base case for the next six to 12 months. In fact, we noticed the price of regular unleaded gasoline rose around 10% last month, and hence we’re not expecting the CPI release at the end of this week to report a big move down for the motor fuel component.
Some think we’re in the midst of a commodity super-cycle, and that’d be a topic for another time. Even if we were in one, that doesn’t mean oil prices will move ever-so higher as the cycle works its way through. We should expect a volatile ride around that trend. That could mean a correction in the oil price that’s just big enough to take down the inflation monster and give stocks a much sought-after boost.
- Given its high volatility, the oil price is a swing factor in the inflation process and therefore important in bringing about relief for the stock market.
- The recent 50+ year record run-up in motor fuel prices materially cuts down the runway for inflationary pressure.
- The war in Ukraine has built up a bigger premium in the oil price compared to episodes that also featured major oil suppliers, leaving it vulnerable to any potential de-escalation in the recent conflict.
- Weakening oil prices was part-and-parcel of nearly 20 disinflationary episodes we studied over the last several decades. We expect the same this time around.
- Across these episodes, the stock market anticipated the peak in inflation and moved higher following it. Inflation fell quicker than it rose leading into its peak.