Central bank policymakers are once again finding themselves in a balancing act as they head into the September round of rate setting meetings, hoping to bring inflation down to the 2% target while minimising damage to the economy.
Rising oil prices mean that their job has got considerably more difficult.
For most of the year, central bankers had help from falling energy prices and base effects, meaning that inflation duly ticked downwards month after month. In the UK, CPI inflation stood at 10.5% in December 2022 and has since fallen to 6.9% on the July reading.
However, going forward policymakers can no longer rely on falling energy prices to do most of the heavy lifting in the fight against inflation. Indeed, oil prices have shot up by almost a third over the past weeks, rising above $90 per barrel earlier this month. Motorists will have noticed the effects of this at the pump, with average prices for petrol and diesel around 10p/litre higher than they were during the summer.
Inevitably, higher fuel prices will also feed through into higher inflation readings. Bank of England Governor Andrew Bailey already admitted as much, stating that we will see an upside surprise to inflation in August compared to forecasts made before the increase in oil prices. However, both he and Chancellor Jeremy Hunt seem to believe that this will be a short-lived blip.
It is, however, worth considering a scenario where higher oil prices stay with us for longer. The US Energy Information Administration sees oil still averaging $88 per barrel next year. By the end of this year, $100 per barrel seems a likely prospect.
In this case, average petrol prices are likely to rise to £1.62 per litre which implies fuel would contribute around 0.17 percentage points to inflation. While this might sound like a small number, it needs to be compared to the substantial negative contribution that fuel had on inflation in recent months – the equivalent figure stood at -0.77 in July, meaning inflation will by be about 0.95 percentage points higher in December due to the increase in oil prices compared to the summer. This might well be the difference between the Chancellor reaching his target of ‘halving inflation’ or missing it – underlining the risk of staking your reputation on figures that are susceptible to external shocks.
Feeding the higher oil prices into our inflation forecast, shows that inflation will still stand at around 5.0% by Christmas. Considering that higher oil prices not only impact fuel prices but also the input costs of businesses across the economy, the impact could be even larger.
Oil importing countries can do little except try to persuade OPEC members to reverse the announced cuts to oil production. Another way towards lower oil prices could stem from a relief of US sanctions on Venezuela – the South American country has the world’s largest proven oil reserves, but mismanagement and sanctions have crippled its oil industry.
What should central bankers do?
Last Thursday, the European Central Bank (ECB) raised rates by a further 25 basis points despite the gloomy economic outlook for the currency bloc. Across the Atlantic, the Fed is expected to hold rates steady this month, benefitting both from weaker inflationary dynamics and a stronger economy.
In the UK, inflation is still too high. Core inflation and services inflation are not yet moving in the right direction which suggests that wage pressures are still feeding through into higher prices. The Bank of England should not claim victory when most of the disinflationary contributions stem from falling energy prices since the start of the year, given that domestic inflationary pressures continue unabated. The recent sharp uptick in global oil prices should be a warning – any potential new exogenous shock could quickly change the picture and reignite an inflationary spiral. We therefore think that the Bank should raise interest rates again in upcoming meeting by a further 25 basis points. The Monetary Policy Committee would then have until November to evaluate if the loosening in the labour market is having the desired effect on domestic inflationary pressures.
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