The unstoppable rise in oil deals a double blow to the economy that “brings us closer to the next recession”

Oil deals a double blow to the economy

The year 2021 was the year of sudden (almost sudden) recovery of demand and consumption, triggering the price of oil, metals, gas and dozens of inptus whose production (supply side) was not prepared for the rapid recovery Of demand. In 2022, calm was expected to come to prices, since all these ‘temporary’ factors had to be corrected in the short term. However, the world has entered 2022 and inflation is still very much alive. The central bank is rushing to tighten its monetary policy, starting a path that should be progressive, but could now be covered in a few months, bringing the US and the world closer to the next recession. What has failed in the plans of central banks, governments and economic institutions?

First, inflation has gone much further than originally believed. Prices have beaten expectations and inflation has spread across almost the entire household shopping basket. The waves of what began as a purely energetic phenomenon have been expanding to all goods and services. Robin Brooks, chief economist of the IIF, published a graph last week in which it could be seen that up to 90% of the components of the American CPI were already suffering a price boom of more than 2%, while in countries such as Germany or Spain the rise in prices touched more than 70% of the basket. Inflation is everywhere and central banking knows it.

Now inflation has its own strength, its decline will be slower and the central bank is forced to take several steps at once. But above all what has failed has been the calculations on energy. Faced with the expected fall in the prices of oil and other raw materials, energy picked up again in January, once again contributing positively to the CPI data. Within energy, gas and oil stand out.

The price of oil is headed for $100 a barrel for the first time since 2014, a figure that very few had in their projections. However, this scenario is now practically a reality and threatens to deal a double blow to the world economy, since expensive oil can affect economic growth, on the one hand, and fuel the inflationary shock on the other.

The price of crude oil has been on other occasions a good indicator to predict the arrival of a recession. 

Recovery and rate hikes

That is a worrying combination for the US Federal Reserve or the ECB, which seek to contain inflationary pressures by trying to hinder as little as possible the recovery of the economy. Although a rise in the price of oil is no longer what it used to be (production is more diversified globally), much of the world (particularly the large net importers) will be affected through ever-increasing costs for companies (transport, energy, oil-intensive inputs…) and some families whose purchasing power will be seriously threatened.

In short, a strong and, above all, prolonged rise in oil prices can harm the economy on the investment/supply side (cost problems it generates for companies) and consumption/demand (if households have to spend a greater portion of their income in energy will have to adjust the belt with the rest of goods and services). As economic theory points out, the demand for energy is very rigid in the short term, since families and companies do not have the capacity to quickly replace the energy sources they use on a daily basis with cheaper or more efficient ones.

According to the Bloomberg Economics Shok model, a rise in crude oil to $100 later this month would lift inflation by about half a percentage point in the US and Europe in the second half of the year. In addition, in the case of the euro zone, it would subtract around 0.3 points of quarterly growth in the first quarter of this year and around 0.15 points in the following. Right now, oil is 50% higher than it was a year ago.

Chris Iggo, CIO Core Investments at AXA IM, warns that the 0.6% monthly inflation increase “could keep annual inflation close to 7% for the rest of the year, which would mean more aggressive hikes by the Fed and would bring the next recession closer”. And he warns: “If we move to monthly increases between 0.6% and 0.4%, annual inflation will fall, but not as much as expected. The risk of a 20% correction in US equity markets and to reach at least a 2.5% yield on 10-year Treasury bonds is very much alive,” says the expert.

Although this may seem like a somewhat exaggerated view, analysts at Bank of America Merrill Lynch have also recently warned that the economy is entering the tail end of the cycle. The covid crisis and the vast response from governments and central banks (stimulus and more stimulus) has accelerated everything. 

From Danske Bank they explained this morning in a note that now “we see upward risks of a scenario in which the Fed pulls the emergency brake earlier and with more force. This would also mean a greater risk of a recession in the future and we do not It would be surprising if the yield curve inverted reflecting greater fears of recession”, say the experts of the Nordic bank.

Why is oil so high?

The price of crude oil has been on other occasions a good indicator to predict the arrival of a recession. In this case, ‘black gold’ is being one of the great drivers of inflation. Among the factors that are driving its price, it is worth highlighting the aforementioned global resurgence in demand, the geopolitical tensions caused by Russia (the world’s largest oil producer) and a supply restricted by OPEC cuts, which although they are being reversed little by little, they do so at a slow pace (400,000 barrels per month). The key to solving this problem quickly and sustainably would be an increase in investment in this sector or the return of Iran to international oil markets, which will mean a ‘jump’ in supply almost overnight. the morning.

Although not to talk about green and renewable energy, fossil fuels (oil, coal and natural gas) provide more than 80% of the energy of the world economy. The cost of a typical basket that includes these products and their derivatives has increased by 50% over the previous year, according to Gavekal Research. This is having an impact on inflation in every country in the world, including the US and the Eurozone.

In the case of the US, Iggo acknowledges that “monthly increases in inflation of 0.6% are quite unusual, so the probability is that we will see some relaxation that allows the year-on-year rate to moderate. But in the short term this It seems more like a hope than an expectation. And what is valid for the US is probably valid for Europe and elsewhere,” says the expert.

Iggo goes on to comment that “inflation remains higher than expected. This means that higher interest rates must be weighed with the potential negative implications for the economic outlook and for risk assets” as “investors they’re wary of fixed income markets because the yields and… they’re wary of equity markets because valuations are still higher than they were before the pandemic.”