With the U.S. inflation standing at 7.7% in October 2022– up from 1.2% in October 2020 – Americans aren’t feeling rosy about their financial futures.
Likely, that’s with good reason. According to a new Equifax survey, U.S. adults say that “inflation, gas prices and paying bills” are their largest financial concerns in 2022.
Those fears are justified given the close ties between oil prices and inflation. According to The Conference Board, leveraging an Oxford Economics global model shows, “2022 annual average inflation could reach 7.6% in the US, and 5.1% in the Euro Area, more than a percentage point above earlier forecasts for the full year,” said Erik Lundh, principal economist at the Conference Board. “Among the consequences: a further deterioration of household purchasing power, already under pressure from rising prices since early 2021.”
According to The Conference Board, a “major and prolonged spike in oil prices risks exacerbating what are already multi-decade high inflation rates and extending this period of elevated price gains even further into the future.”
What Investors Need to Know About Oil Prices and Inflation.
Wall Street investment firms expect the price of oil to rise further in 2023, increasing from $85 per barrel in October 2022 to $94 per barrel (Bank of America forecast) and up to $100 per barrel (Barclays forecast).
Bank of America notes that this is primarily due to a “modest but demonstrable production cut at the last OPEC meeting.” Simultaneously, Barclays expects oil industry-related inflation to be a thorn in the side of financial markets, with the additional costs of oil production hiking the cost of business for oil companies up to an estimated 20%.
That, in turn, may feed into more inflationary fears in 2023.
What does that mean for investors looking for more clarity on oil, inflation and the economy next year?
Here are three things to know.
Oil and inflation are tied together – and have a huge impact on the economy.
History shows that gas prices and household inflation expectations are closely correlated.
“Clearly, large spikes and declines in gas prices are associated with similar movements in inflation expectations,” noted Carola Binder, associate professor of economics at the Mercatus Center at George Mason University in a recent search note. “For example, as gas prices rose from $2.64 per gallon in February 2010 to a peak of $3.91 per gallon in May 2011, inflation expectations simultaneously increased from 2.7 percent to 3.8 percent. Both series declined together for the latter part of 2011,” Binder said. “More recently, gas prices and inflation expectations have both spiked even more notably.”
That identical pattern holds over a longer period.
“Though the gas price data are not available until 1990, gas prices are highly correlated with oil prices, which are available since the beginning of the University of Michigan survey data, in 1978,” Binder said. “From 1978 to the present, the correlation between consumer inflation expectations and real oil prices is 0.44. That is, consumer inflation expectations rise when gas prices rise and fall when gas prices fall.”
Oil prices have a direct impact on other consumer goods as well.
Investors who favor consumer goods, manufacturing, retail, and other backbone industry sectors historically face steeper costs when oil and inflation march forward.
A case in point.
Energy composes approximately 7.3% of the U.S. consumer price index.
Think about consumer products, like petrochemicals in plastics or life-saving medical devices like pacemakers and MRI machines. Most obviously, the transportation sector relies on oil and gas to move vehicles around, and that isn’t easy when oil costs make up half the retail price of gasoline – and when oil prices are ascending.
This may be why Federal Reserve Chair Jerome Powell testified to congress earlier this year that, in general, each $10 per-barrel crude oil price hike boosts inflation by 0.2%. In that same scenario, economic growth, as measured by gross domestic product, by 0.1%.
Weighing The PPI effect.
While commonalities between oil, inflation and impact on CPI are abundant, the same factors (and results) are in play with the Producer Price Index (PPI), which tracks goods prices at the producer level.
In general, PPI measures the changes in the cost of producing goods. PPI was up 8.5% on a year-to-year basis, as of September 2022. As oil prices rise, those higher costs affect producer costs.
Those higher production costs are forwarded to retailers, and on to the consumer, adding to CPI.
Additionally, the symmetry between oil, prices and the PPI are tighter than oil and the CPI. According to the St. Louis Federal Reserve, the direct correlation between oil prices and the PPI stood at 0.71 between 1970 and 2017. That range is much more robust than the link between oil prices and the CPI, which stands at about 0.27 over the same time period.
Investors may want to keep a close eye on the PPI index, as it’s a robust indicator of when inflation may rise.
"The weaker link between oil prices and consumer prices likely comes from the relatively higher weight of services in the U.S. consumption basket, which you’d expect to rely less on oil as a production input," the St. Louis Federal Reserve stated.
The Takeaway on Inflation and Oil Prices.
No doubt, the run-up in oil prices and higher inflation have led to adverse stock market conditions in the second half of 2022. (The Dow Jones Industrial Average index is down 20% since its early January high.)
With both inflation and oil prices rising after OPEC’s October decision to cut production, the tendency for investors to overreact is high, especially when any further Federal Reserve rate hike activity is expected.
That’s the scenario right now as investors are anxious over the Federal Reserve curbing U.S. economic growth too much and steering the U.S. into a recession.
Such a scenario would be unfortunate, as any recession is toxic to stock market growth, especially as downward economic activity causes both consumers and businesses to rein in spending, which triggers a big decline in corporate revenues.
To keep on top of market activity, investors need to keep a sharp eye on inflation and oil prices, and where they’re trending. If prices continue to rise due to rampant inflation, the Federal Reserve may continue to boost interest rates to slow economic growth – making both oil and inflation leading indicators heading into 2023.
For better or for worse.
Enjoyed the read? Sign up for our newsletter at the top of this page.
Make sure to follow us on:
Yieldwink is a digital platform linking investors to highly vetted private investments in an effort to lower volatility, provide higher levels of income, and enhance returns.