April 27, 2018 / 10:40 AM / 3 months ago

Column: Will oil prices finally give teeth to inflation's bite?

LONDON (Reuters) - 2018 was supposed to be the year inflation bared its teeth, finally emerging after years of unprecedented stimulus in a booming global economy.

FILE PHOTO: Sample bottles of crude oil are seen in this illustration photo June 1, 2017. REUTERS/Thomas White/Illustration/File Photo

The Fed is well down the path of normalizing policy, with other central banks about to follow. And right on cue, the prices of oil and other commodities are accelerating sharply.

But the latest inflation reports from major economies were surprisingly soft, casting doubt on how far rates should be raised. Maybe price pressures aren’t as strong as central banks had bargained for.

The first insight into April’s figures next week, starting with the euro zone, could be pivotal to investors’ 2018-19 interest rate expectations.

The surging oil price right now will be giving policymakers food for thought. According to the International Journal of Economics and Finance, oil has a “statistically significant” effect on inflation rates in G7 nations.

In a paper published last year, it found that oil prices are responsible for 17.4 percent of changes in G7 inflation rates. When oil falls below $34.50 per barrel, the effect on G7 inflation rates turns negative.

An International Monetary Fund paper last year showed that a 10 percent rise in oil prices typically increases domestic inflation by 0.4 percentage point in the short term, or the year of the price increase, with the effect vanishing after two years. That applied to both advanced and developing economies.

Oil is well above $34.50, and it has risen far more than 10 percent in the past year. Brent crude futures this week hit $75 a barrel and U.S. WTI nudged $70, both up around 45 percent over the last 12 months and up 65 percent from the low of June last year.

The price of other commodities is rising, too. Over the past year, the Thomson Reuters/Core Commodity CRB Index is up 20 percent.

All else equal, this suggests inflationary pressures are bubbling away under the surface, something policymakers need to take into account today as they set policy for tomorrow.

Bond yields are moving up in response. Citi’s global 10-year world bond yield is the highest in more than four years at 1.4757 percent, lifted by the U.S. 10-year yield’s rise above 3 percent.

INFLATION DOUBTS

But a sustained rise in inflation across the developed world remains elusive.

The U.S. core PCE price index, the Fed’s favored inflation gauge, is inching higher and is now 1.6 percent. That’s the highest in a year, but it’s still comfortably below the Fed’s target of 2 percent. It’s been below target for six years, and has only been at or above that 2 percent threshold five months in almost a decade.

In Britain, figures earlier this month showed that headline CPI slipped to 2.5 percent in March. That was a surprise - economists had expected it to remain steady at 2.7 percent. In January it was 2.9 percent.

The decline this year has caught markets and policymakers off-guard. JP Morgan Asset Management reckons inflation might fall below 2 percent by the end of the year, and the May rate hike that was considered a 90 percent probability last week is now given just a 20 percent chance.

Euro zone inflation has also been on the soft side. Headline inflation was 1.3 percent in March, below the forecast 1.4 pct. It hasn’t been above 1.5 percent for over a year, or above 2 percent since 2012 (The ECB’s target is “below, but close to” 2 percent).

Economists at HSBC expect headline euro zone inflation to be just 1.4 percent this year and next, despite the rise in oil prices, and recently cut their 2018 core inflation forecast to 1.0 percent from 1.1 percent.

These changes and deviations from forecast are small, but their significance could be big. Another month of weaker-than-expected inflation, even if the undershoot is a tenth of a percentage point, and markets’ rate hike expectations will surely diminish further.

Reporting by Jamie McGeever, editing by Larry King

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