Higher oil hurts

The oil market has flipped into supply deficit since June and is likely to remain so in the months to come. Moreover, oil inventories are uncomfortably low, increasing the risk of higher price volatility. The situation in the US is particularly critical as commercial and strategic crude oil inventories combined are at their lowest level since the 1980s. Nonetheless, oil prices have recently reached levels typically tend to dent demand. Furthermore, some important oil projects in the non-OPEC+ world are expected to gain momentum. Overall, we expect oil prices to remain volatile, fluctuating in the USD85-USD100 range in the months to come.

As for the impact of the recent trend higher, almost all post-World War Two recessions in the US have been preceded by, or accompanied by, a sharp rise in oil prices (and monetary tightening). We expect the recent rise in oil prices, if sustained, will lower GDP growth in the US and raise headline inflation. A 10% rise in the oil price is typically estimated to subtract 0.15% from GDP growth via lower consumption, only slightly offset by higher capital spending by energy corporations. However, the impact of higher oil should be much more contained than in the 1970s/1980s as the US economy is less energy dependent and inflation expectations remain remarkably well anchored. A sustained 10% increase in oil prices should push headline inflation by 30-40bps in the next six months. However, we do not expect higher energy prices to raise core inflation materially and thus derail the recent disinflationary trend.

Given the laundry list of risks already looming for the US economy, the negative growth impact of an oil shock should reinforce the Federal Reserve’s prudent stance and we expect it to refrain from further rate hikes. But given above-target inflation, risks of a stronger pass-through to core inflation and of un-anchoring inflation expectations suggest the Fed will continue to guide towards holding rates elevated for quite some time.

As for the euro area, we are sticking with our GDP growth forecast of 0.5% for 2023. However, the recent rise in oil prices has increased downside risks. The pass-through of higher oil prices is difficult to estimate and a lot depends on whether the price rise is temporary as well as the degree of the price shock. The European Central Bank (ECB) estimates that a 10% rise in oil prices can push the consumer price index higher by 0.16% directly and by around 0.20% indirectly over a period of up to three years. The ECB also reckons that “a 10% increase in oil prices reduces real GDP in the euro area by about 0.24% after three years, assuming no monetary or fiscal reaction”. 

All in all, recent oil price increases will probably keep the ECB hawkish. Oil prices that remain higher than its staff assumptions (of USD81.8 per barrel in 2024 and USD77.9 in 2025) could push the ECB’s headline inflation forecasts up and potentially delay achievement of its 2% target. However, at this stage, we continue to expect the ECB to stay on hold for some time.