- Oil prices surged this year because of global GDP growth and War in Ukraine.
- Rising oil caused gasoline prices to skyrocket, hurting consumers.
- Gasoline is a large contributor to changes in inflation measures.
- Recent declines in oil and, thus, gasoline suggest prices could start declining year-over-year early next year.
- The Federal Reserve watches inflation closely to determine policy, so declining inflation could put future hikes on pause.
Surging crude oil prices caused gasoline prices to skyrocket this summer, forcing consumers to shift spending toward necessities and crimping economic activity. Moreover, the War in Ukraine continues to jeopardize Russian supply, putting upward pressure on oil. Still, emerging green shoots suggest oil’s negative impact on inflation is fading and may disappear as early as March.
The Consumer Price Index, an inflation measure, was already trending higher before Russia invaded Ukraine on Feb 21. However, it accelerated afterward. For example, it was 1.4% in January 2021, 5.4% in September 2021, and 9% in June 2022.
Initially, a rebounding economy and tight supplies following shut-in production caused by COVID-era lockdowns were the cause. More recently, Western sanctions on Russia to encourage them to abandon their Ukrainian plans were responsible. Prices have also increased because producers, including OPEC, were reluctant to uncork production.
We’ve seen little to suggest Russian sanctions will end. On the contrary, the chatter about price caps suggests they’re intensifying. Nevertheless, the negative gross domestic product caused by Fed interest rate increases this year, recent sales from the strategic reserve, and higher shale production are relieving oil price pressure. As a result, gasoline prices aren’t nearly the drag on consumers as they were about two months ago when prices were about $5 per gallon.
West Texas Crude was trading at $82 per barrel earlier today, far below its $120 price in June. Meanwhile, the average price for one gallon of gas was $3.86 last week, 23% below what it cost in June. Prices remain higher year over year, but if gasoline prices remain near current levels, tougher comparisons next year mean prices may decline year-over-year as soon as March 2023. If so, gasoline prices' impact on CPI may contribute to lower inflation next year.
Although gasoline’s weight in headline CPI inflation is below 4% (sidebar: energy overall is ~7.5%), the Dallas Federal Reserve calculates that gasoline accounts for about 63% of CPI variability because of its volatility. Gasoline’s impact on the core (inflation excluding energy and foods) CPI is smaller but not insignificant, given oil is an input cost for much of the economy.
Last November, the Dallas Fed concluded that “in early 2021, the recovery in gasoline prices added as much as 4.9% to headline inflation.” Further, a model exploring the impact of $100 per barrel of oil resulting in higher gasoline prices suggested it would add 5.7% to headline CPI and 1.3% to core CPI. Once the model stopped increasing gasoline prices, “inflationary effects of positive gasoline price shocks vanish almost as soon as gasoline prices stop rising.”
Of course, while the media focuses a lot on CPI, another measure – the personal consumption expenditures (PCE) – is what the Fed largely tracks to determine its interest rate policy.
Differences in calculation mean gas prices have a less notable effect on headline PCE, accounting for 55% of its variability. However, it has a larger impact on core PCE than on core CPI, accounting for 15% of variability versus 7%.
The long and short of all this is that changes in gasoline prices have an effect on inflation rates, so declining gasoline prices could be an important cog in determining the path of CPI and PCE, thus, the likelihood of when the Federal Reserve shifts from investors’ enemy to its friend.
Of course, nobody knows what will happen from here. Prices could climb again if the situation in Russia spreads or producers significantly ratchet back production. Recently, OPEC said it would roll back the 100k barrels of additional production per day it added to markets in August. However, that’s a drop in the barrel (0.1% of global demand) compared to the cuts that might be necessary to support prices if a recession causes demand to fall off a cliff worldwide.
The U.S. has already delivered negative GDP in the first and second quarters, and the situation in Europe looks dire. Record high natural gas prices are causing plants to shutter activity, and recession is on the table throughout the EU.
For perspective, after per barrel prices peaked during the Great Recession in the summer of 2008, they fell to $32 from $142, despite OPEC cutting production by 1.5 million barrels in November and 2.2 million barrels in December 2008. In short, OPEC would need to be far more aggressive if they want to sure up prices if global demand contracts because of recession worldwide. Let’s not forget that China is a huge consumer of these products, and its economy is also stuttering.
U.S production isn’t shabby, either. U.S. weekly field production totaled 12.1k barrels on August 26, up from a low of 9.7k barrels in August 2020 and 11.5k barrels the year prior. For perspective, peak production was 13.1k barrels before COVID shutdowns, and production 5-years ago was about 8.5k barrels.
The Smart Play
Gasoline prices historically peak during the summer driving season and trend lower in winter, so seasonality could mean that prices did put in their high during June for this cycle. However, offsetting seasonal trends is that sales from the U.S. strategic petroleum reserve designed to add 180 million barrels or roughly 1 million barrels per day (about 5% of U.S. daily demand) are scheduled to end in October.
It remains to be seen how easily the market will absorb the discontinuation of the reserve release. Still, perhaps, seasonality, declining demand caused by slowing global economic activity, and higher U.S. production offset it, helping gasoline prices stay, at a minimum, near where they are now.
If so, lower oil and gasoline prices could reduce the likelihood that consumers and businesses extrapolate high prices into the future, allowing them to put a lid on future price increases, thereby helping to keep core PCE in check. Admittedly, this is all guesswork. Nevertheless, decelerating inflation would provide the Fed with some cover to move to the sidelines.
If gasoline prices do flip to a year-over-year decline in March, it would coincidentally happen at the same time that every hike through September rolls out of Martin Zweig’s Fed Indicator, a measure designed to signal investors when the Fed is likely to reward or punish investors based on rate policy.
Zweig, who coined “Don’t Fight the Fed,” removes the negative impact of each rate hike after six months. Currently, the indicator stands at “very bearish,” but if rate hikes end in December, it could move to moderately bearish in March and, absent any additional increases, neutral by June. As you can see in the previous table, an improving indicator can make the path easier for stocks to gain ground.