We like to criticize the Fed when inflation increases, but credit it when inflation declines. This is done more out of habit than on the basis of the evidence. Today there is another and more powerful factor at work. The price of oil is a major leading indicator of Washington’s inflation statistics. It’s a major factor in the cost of living worldwide; not merely the most prominent driver of energy costs, but also an influence on the prices of food and numerous other goods to whose production energy is an input. The oil price is also a wild card. Fast-moving geopolitical events can change it dramatically.
So the recent downswing – from over $120 a West Texas barrel in July to under $75 at the end of the year – goes a long way to explain the easing of inflation that followed. Given the extreme volatility of oil prices and their dependence on politics, oil is capable of a major rebound – taking the cost of living along for the ride. Widespread optimism about inflation is therefore premature. It depends on the direction in which the price of oil moves next.
While oil leads inflation, it lags behind the depreciation of the dollar relative to a constant monetary standard. I’ve found the best (and earliest) expression of that in the price of gold in forward markets. Just as currency movements anticipate the relative inflation rates among different countries so, in each country, movements in forward gold (expressed in local currency) anticipate both oil prices and the national inflation rate.
Failing to anticipate the outbreak of inflation in 2021, the Fed at first thought it would be “transitory.” When this turned out wrong, a major hole in the Fed’s understanding of the economy was revealed. Faith in Fed doctrine nevertheless persists. People think (or hope) that rate hikes caused the rate of inflation to begin declining a few months ago, and that the worst is over. But Fed thinking may well continue to be wrong again. This time, ironically, it’s the abatement of inflation that is transitory. Energy prices are a loose cannon.
Both crude oil and gold prices are set on a worldwide basis. Historically there has always been a close parallel between them, especially where the most dramatic changes are concerned. It was no accident that the US decision to unhitch the dollar from gold at the end of the 1960s was followed by Saudi Arabia’s oil-price mega-hike. Gold increased more than tenfold, and soon after so did oil. It’s no exaggeration to say that the oil price is determined over time primarily by the course of the dollar in terms of gold.
History in fact shows that the ratio between the two prices is strongly norm-reverting, a real-time guide to whether oil is “cheap” or “dear” in real terms. Norm reversion begins quickly, but it’s asymptotic. I calculate that it takes over two years for an elevated or depressed ratio to revert halfway back. The norm is not a constant, but shifts slowly over time, reflecting long-term supply constraints and other factors. But it’s amazing how much the dollar’s depreciations contribute to oil-price behavior over time.
The price ratio between oil and forward gold was roughly stable until the second half of 2022. Then it plunged, ending the year more than 40 percent lower. Following Western sanctions on the Russian oil industry, the chaotic state into which the world oil market fell had pushed the oil-gold ratio away from equilibrium. Shut out of Europe, Russia is discounting its oil to expand its exports to China, and to attract big new customers like India. The resulting decline in energy prices was huge and has had a major effect on the cost of living, making it look as if inflation has peaked. But it’s unlikely that oil will stay cheap. Sanctions can only reshuffle oil-supply relationships. As a new pattern of trade evolves, the oil-gold ratio will move back toward the status quo.
What goes up comes back down, that’s often true. But in this case what goes down comes back up. The next big move in the price of oil is likely to be upward, and it will bring with it a reacceleration of the US inflation rate.
