LONDON (Reuters) - This year’s 65 percent rebound in oil prices mirrors 2015’s premature recovery but if sustained it will lift headline inflation rates with many central banks ever deeper into emergency deflation-fighting mode.
Even if Brent crude just stays where it is now, economists reckon its steep rally from January’s 12-year lows could add well over a percentage point to inflation next year.
“Central bank policy operates with a lag of around 18 months so the principal concern should be where’s inflation going to be in 18 months,” said Paul Donovan, Managing Director, Global Economics at UBS.
“If oil holds steady, euro zone inflation will probably be around 1.7 or 1.8 percent by the end of 2017. By any measure that’s pretty close to the ECB’s target, and questions whether more accommodative policies should be pursued at this point.”
The European Central Bank’s definition of price stability is inflation “below, but close to” 2 percent over the medium term. But, together with the Bank of Japan, it is at the forefront of a global battle against the threat of deflation.
The BOJ stunned markets in January by adding negative interest rates to a massive asset-buying program to hit its own 2 percent inflation target, while the ECB has effectively offered to pay banks to lend to firms in the euro bloc.
Headline inflation in the euro zone is currently zero and was last at 2 percent in January 2013. The ECB is one of 49 central banks to have eased policy since the beginning of last year to lift inflation, boost growth, or in some cases both.
The fall in Brent oil from $115 in June 2014, due to both oversupply and softening demand, is the main reason for the ‘lowflation’ - and in some cases, deflation - around the world.
Karen Ward, chief European economist at HSBC, notes that energy price declines over the past year are subtracting 0.8 percentage points from the current headline euro zone inflation rate.
And so even if current prices are maintained, that will be a positive 0.4 percentage points early next year, representing a hefty 1.2 percentage point swing.
“Oil is a game-changer,” Ward said.
“As inflation picks up the fear of getting into a Japan-style deflation rut will recede. But underlying growth is still fairly subdued so this rise in oil price won’t be leading to any rampant inflationary pressure,” she said.
While the ECB and other central banks focus on headline inflation, policymakers also pay close attention to trends in core inflation which strip out the traditionally more volatile swings in food and energy prices.
There, the signals are mixed. Core inflation in the euro zone has been drifting higher over the past year but is still only 1 percent. The last time it was above 2 percent was 2008.
Still, the rebound in crude is significant. Not only has oil bounced back strongly off its lows, it is now flirting with a potentially crucial long-term technical level on traders’ charts.
Brent moved back above its 200-day moving average earlier this month for the first time since July 2014. That key technical level is now just above $43 a barrel, with the spot price rising toward $46.
However, the last couple of years have cast an element of doubt on the economic models on the traditional relationships between oil, growth and inflation.
The consensus view two years ago would have been that a 75 percent decline in oil prices would give a major shot in the arm to consumer spending and overall growth. But that didn’t happen, and low oil prices are now equated with sluggish demand and general economic weakness.
Carsten Brzeski, chief economist at ING-DiBa in Frankfurt, reckons a 20 percent rise in oil should lead to an increase in inflation by as much as 0.4 percentage points, meaning the near 60 percent rise since mid-January could lift inflation by over 1 percentage point.
This would be welcomed by central banks such as the ECB worried about the threat of deflation, and those like the U.S. Federal Reserve and Bank of England who are already grappling with stronger growth and tighter labor markets.
“This would be enough to save central banks from having to do even more to tackle deflation,” Brzeski said.
“On the other hand, it would probably be too little to force central banks to reconsider their policy stance, particularly in the euro zone, where high unemployment rates will keep core inflation at bay,” he said.
Reporting by Jamie McGeever; Editing by Toby Chopra