Column: Inflation shock threatens oil consumption and prices

A gas pump is seen in a car at a Shell gas station, after a cyberattack crippled the biggest fuel pipeline in the country, run by Colonial Pipeline, in Washington, D.C., U.S., May 15, 2021. REUTERS/Andrew Kelly/File Photo

LONDON, Feb 10 (Reuters) - Rapid inflation and the need for the major central banks to bring price increases back under control has emerged as the biggest headwind for oil consumption and prices later in 2022 and 2023.

U.S. consumer prices have increased at a compound annual rate of 4.4% over the last two years, twice as fast as the Federal Reserve’s long-term target of slightly over 2.0%.

Over the three months to January, consumer prices were advancing at an annualised rate of 8.0%, implying that inflationary pressure has been intensifying rather than moderating.

The consumer price index published by the Bureau of Labor Statistics on Thursday showed every category - including merchandise, services, food and energy - rising much faster than the central bank’s target.

As a result, U.S. interest rate traders are pricing in six quarter-point interest rate increases (or equivalent) before the end of 2022.

The Federal Reserve is under increasing pressure to prove it can bring inflation back under control before it becomes entrenched in wage- and price-setting behaviour.

U.S. consumer and business demand has been rising faster than manufacturers and service providers can increase the supply of goods and services, leading to shortages and upward pressure on prices.

But the problem of excess demand (or deficient supply) is playing out across the other advanced economies and their less-advanced counterparts in the developing world.

The Federal Reserve and other central banks cannot close the gap by increasing supply much in the short term, so it must be eliminated by slowing growth in demand to give supply a chance to catch up.

The inevitable result will be slower growth in oil consumption, possibly starting later in 2022, but almost certainly in 2023, creating conditions for the next cyclical downturn in prices.

TIGHTENING CYCLE

Sustained monetary tightening on this scale, coupled with the intense squeeze on real household incomes from inflation, is likely to result in a slowdown in the rate of economic and oil consumption growth.

Rising real interest rates in the United States and most of the other advanced economies will tend to slow the pace of demand growth (which is after all the point of raising them).

More importantly, rising rates in the advanced economies at the 'core' of the world economy will tend to have an even bigger impact on slowing growth in the developing economies on the 'periphery'.

Historically, rising interest rates in the core slow or even reverse capital flows to the periphery, tightening credit conditions there and increasing financial stress on businesses and households.

Slower growth in the core also tends to spill over to the periphery, where many economies depend on exporting raw materials or manufactured items to the core economies.

Developing economies account for almost all growth in oil consumption, so a slowdown in Asia and to a lesser extent in the Middle East will translate into slower increases in oil demand.

Fed interest-rate raising cycles starting in 1994, 1999, 2004 and 2016 all ended with a deceleration in oil consumption and a fall in oil prices.

Interest rate rises are a symptom of strong demand, so they can coincide with a continued escalation in oil prices in the short term.

But in the medium term, the progressive tightening of financial conditions and slower economic growth will eventually sap oil consumption growth and cause prices to fall.

In contrast to recent interest rate cycles since 1990, the Federal Reserve starts this one much further behind the curve, with inflation already far above target.

From this awkward point, the central bank may find it hard to stick to gradual increases, heightening the risk of turbulence in financial markets and making a soft landing harder to achieve.

Chartbook – U.S. inflation: https://tmsnrt.rs/3HJG9yH

Chartbook – U.S. interest rates: https://tmsnrt.rs/3rF40tI

Related columns:

- Fed searches for elusive soft landing (Reuters, Feb. 2) read more

- Commodity prices likely to be hit by slowdown before end of 2023 (Reuters, Jan. 27) read more

- Escalating U.S. inflation forces macro policy rethink (Reuters, Jan. 13) read more

- Global economy faces biggest headwind from inflation (Reuters, Oct. 14)

John Kemp is a Reuters market analyst. The views expressed are his own.

Editing by Barbara Lewis

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John Kemp is a senior market analyst specializing in oil and energy systems. Before joining Reuters in 2008, he was a trading analyst at Sempra Commodities, now part of JPMorgan, and an economic analyst at Oxford Analytica. His interests include all aspects of energy technology, history, diplomacy, derivative markets, risk management, policy and transitions.