Give and take
15 May 2018
US consumers are already feeling the effects of higher oil prices. Perhaps the most commonly used anecdote is how much it costs to fill your car. Gas prices have jumped 28 cents a gallon since the turn of the year to $2.75 – an 11% increase over this short period. While gasoline consumption has been declining steadily on the back of fuel efficiency gains and shorter average distances driven, this still equates to an average increase in household bills of close to $300 a year. However, oil prices do not only affect consumers through gas prices. Indeed, the broader energy component accounts for around 8% of the CPI basket, and alone is contributing 0.5 percentage points to headline inflation at present (see Chart 2). Finally, higher oil prices feed indirectly into consumer prices via higher production costs for non-energy goods. The IMF has estimated that this channel contributes around a third of the overall shock from higher oil prices to domestic inflation. The upshot is that further oil price driven increases in annual US inflation rates are likely on the way over coming months, before gradually fading over the second half of the year.
Typically this jump in inflation would serve to weigh on growth, by dampening household incomes and corporate margins. However, changes in the US energy sector over recent years will push in the other direction. US crude oil production surpassed 10 million barrels per day late last year, a benchmark not hit since 1970. This makes the US the third largest oil producer in the world, helped by transformative technological breakthroughs in the shale sector. The upshot is that higher oil prices will boost activity, employment and investment in this sector and related industries. Indeed, we have already seen the Baker Hughes rig count start to rise, albeit to levels still around half of the 2014 peak. Changes in the energy sector also affect trade. The US petroleum deficit has shrunk notably over recent years, helping partly mask an alarming rise in the non-petroleum gap (see Chart 3). Higher oil prices will therefore have a smaller effect on the overall deficit. So what is the net effect? Research by Brookings found that the boost to incomes/margins from low inflation was offset by sharp declines in oil investment during the 2014 and 2015 fall in oil prices. However, this time may be different. Tighter credit conditions in the sector, scrapped drilling and fracking equipment, uncertainty over longer term-oil prices and skills shortages could all dampen the boost from oil investment. Overall, rising oil prices should still provide a drag on growth, albeit a much smaller one than we might have expected a decade ago.
The Fed will be watching this trade off closely. With both headline CPI and PCE measures of inflation above target, and core indicators very close to this goal, it is increasingly confident that the drags seen over the course of 2017 were temporary in nature. If we are right that inflation pushes higher in coming months then this may add to calls for a faster withdrawal of policy accommodation from more hawkish quarters of the Federal Open Market Committee. However, the committee has been at pains to signal that its inflation target is symmetric, meaning that it will not react disproportionately to temporary overshoots. Indeed, the Fed has up until now been relatively happy to look through the effects of rising oil prices, keeping its focus firmly on domestic fundamentals. This approach is expected to continue, barring any sharp shocks.