Why The Price Of Oil Is So Important To Central Banks?

Last week we wrote that the US inflation rate was the "one chart to rule them all" as it is determining nearly everything in global financial markets, the broader economy and, indeed, regular everyday life.

This financial and cultural range really nails the immense power of rising prices. It is one of the few forces that can truly focus minds and command attention on Wall Street and Main Street simultaneously.

From the boardroom to the bar and even the classroom, everyone knows about inflation. Last week we got to hear what everyone else thought, from the woman on the street to the CEOs of many corporations. This week we got greater clarity about how the US central bank, the Federal Reserve, thinks about the US economy's current situation.

In doing so they frightened investors extremely and also helpfully brought together two of our most significant Pebble themes: the battle versus inflation and the price of energy.

*******

Unless you were either living under a rock or are deliberately ignoring all financial news (except for this newsletter, you discerning genius) you are fully aware that the Federal Reserve hiked interest rates on Wednesday.

The upshot was this: the Fed "surprised" markets by hiking by 0.75% rather than the 0.50% they had previously suggested was likely. It was the largest increase in US interest rates since 1994.

This increase wasn't really a surprise because most commentators and analysts had quickly decided that higher than expected inflation on Friday meant a commensurate higher interest rate hike than expected on Wednesday.

This confirmed the Federal Reserve's renewed determination to get inflation under control and willingness to - finally - act decisively and even creatively to achieve this goal.

There are only two problems:

  1. As Chair Jay Powell himself noted, a lot of the current inflation is caused by the rise in energy costs which, for both oil and natural gas, is directly a product of the exogenous shock created by the war in Ukraine.

  2. And the cost of reversing this fact will be severe. This was made crystal clear than the fact that the Federal Reserve FOMC committee withdrew this sentence from their opening statement: With appropriate firming in the stance of monetary policy, the committee expects inflation to return to its 2 per cent objective and the labor market to remain strong.

The much discussed "soft landing" appears to be now off the table.

Ominous.

On the first point, Jay Powell and the Committee are correct. Here is the breakdown of the 8.6% May CPI report:

But this raises a challenging question: if inflation is largely being driven by higher energy costs and inputs then what exactly will rate hikes - of any magnitude - do to counteract this?

Why would inflation that is primarily produced and driven by some outside shock and totally disconnected from underlying global demand, be the catalyst to hike even further?

Thus, if the Fed must overcome the constrained global oil supply situation brought about by the Ukraine war and Russian sanctions then it will.

  • In other words, exogenous shock or not - the Fed will create conditions to curb oil demand sufficiently to lower its price significantly.

The problem with this nice little story is that there is really only one way to achieve this outcome - hammer the economy.

Because, by definition, if the global economy is growing then it uses quite a bit of oil. And, of course, the reverse is also true: a shrinking economy will.....

And this brings us to our second point.....

The Federal Reserve has, very tacitly and yet importantly, shifted their stance yet again. First we had the whole tiresome "transitory" debate, then we discussed what and how serious the non transitory inflation issue actually is and now we are finally getting to the: "what must be done" element of the problem.

  • Specifically, the Federal Reserve is quietly dropping its argument that it will be able to tighten monetary policy without overly damaging the economy.

  • i.e.: you. me. all of us.

As we said earlier: this is....ominous.

And that unstated acknowledgement underlines the nasty reality (and real tradeoff) we have discussed before. The chance of a "soft landing" for this tightening cycle whereby the US central bank can tamp inflation without seriously harming the US economy, was always going to be difficult.

  • The issue of a soft landing used to be a debatable point of the "will they, won't they" type and with an inherent tension point about what was driving inflation expectations. Increasingly both the debate and the tension point are irrelevant.

This isn't really new. We have been worrying about the risks of a Federal Reserve-induced recession for months. But now our fears and the Fed's formal statement this week, overlapped for the first time.

The Federal Reserve is a powerful institution with a key role in determining how fast or slow the economy can grow. But their challenge is that the available tools are also incredibly blunt.

The Fed isn't equipped for precision. It is equipped for hammering.

And now it is dropping all the pretense of protecting the economy. In a final acknowledgment of how severe the inflation threat has become, the central bank has decided that, to paraphrase MC Hammer, "stop, it's hammer time" and it is the economy that is going to get it.

It is nearly a year late but the central bank has finally decided to do whatever it takes and damn the consequences, you are getting a recession.

And that is why markets have been dropping 2%+ a day. An economic recession is no fun and if the central bank wants one, they will likely succeed.

Here is another great proxy. Corporate high yield (i.e.: risky) debt has sold off incredibly quickly as investors realize that corporate revenues and profits (and the ability to pay back debt as a result) will be severely damaged.

As the quote at the start of this newsletter implies, a world where credit isn't just expensive but practically unavailable will be one where growth only goes one way.

I guess at least they finally said the bad part out loud?

*******

Have questions? Care to find out more? Feel free to reach out at contact@pebble.finance or join our Slack community to meet more like-minded individuals and see what we are talking about today. All are welcome.

    Previous
    Previous

    2022 Theme: Tight Energy Markets - US LNG Finally Goes Boom

    Next
    Next

    Pebble raises $5M to make investing more personal