Will Rising Oil Prices Act as an Inflation Stabilizer?
After shrugging off the first signs of blatant protectionism, the markets have begun to focus on the battle between inflation and deflation. The good v. evil debate was reignited when BoE governor King suggested that reserve hoarding at banks was hindering QE. Moreover, he was concerned that if the banks do not lend then a deflationary spiral may take hold.
However, to date the data does not support his fears. The UK National Statistics office released several measures of CPI and on a monthly basis, August CPI was up 1.6% v. 1.8% previous. While below the traditional 2% target zone, the gauge is far from showing deflation.
King’s argument is based on the output gap, or the difference between what the economy is capable of producing and what it is producing. King, along with virtually every other central banker, believes that the slack in the economy will keep inflation rates low. We have long agreed with this view. The flaw in our collective thinking is that relying on past estimates of the potential for current economic production assumes the world economies are functioning normally.
The trillion dollar question is how much damage has the credit crisis done to the output of the global economy. A large part of global GDP is comprised of financial services, which of course has been severely hobbled. Additionally, financial services serve as the mechanism to distribute capital efficiently. Clearly a broken financial system will leave capital stranded and/or hoarded.
This hoarding is occurring across the globe, but most notably in the UK and in the US. Both King and Bernanke have suggested that the next step for monetary policy is to reduce the amount of excess reserves held at banks. The most popular way to accomplish this has been called the “Swedish Model.” Sadly this model is less exciting than the name implies.
In July, the Swedish Riksbank decided to charge banks 0.25% on excess reserves. The goal of the program was to get banks lending once again. Now this model is being contemplated on both sides of the pond . The question now shifts toward the inflationary impact of the Swedish model.
Governor King seems to believe that an inflation rate below 2% has deflationary implications and suggested that the BoE may indeed take action; on this news the Pound has been weak.
In a sublime bit of carefully planned serendipity, the US PPI was reported after the UK inflation report. The report showed that higher energy costs contributed to higher producer prices. Energy costs climbed 8% and gasoline specifically surged 23%. The result of the increase in crude oil and gasoline was a significant jump in the cost of crude goods for further production. The rise in crude goods means inflation is in the US pipeline.
Certainly Governor King is a well educated, astute central banker and must have access to crude oil prices. Therefore we can safely assume he is aware of rising oil prices. So why then is the Governor so concerned about deflation?
It is our hypothesis that rising oil prices will act as an automatic stabilizer for inflation. We can see evidence of this phenomenon in the retail sales report.
As gasoline prices rise, sales at gas stations do not rise as much, implying higher gas prices cause consumers to cut back. It is this self regulating economic development that could keep inflation in check as producers will be unable to pass along price increases.
Rising oil prices will act as a brake on economic activity and it this “brake” that the bond market could be anticipating.
Despite rising oil prices and the prospect of a robust economic recovery, bond prices have been rising causing bond yields to fall.
Curiously, as oil prices have retreated over the last several days, bond prices have followed. The implication of this move is that, counter-intuitively, bond investors see rising oil prices as an economic drag.
