Could Higher Oil Prices Force a Reassessment of Core Infllation?

by: James Picerno

The only thing worse than a slowing economy is a slowing economy harassed by rising oil prices.

That unpleasant combination seems to threaten at the moment. The U.S. economy shed jobs on a monthly basis in August for the first time in four years, while a barrel of crude oil has made a fresh run upward to just under its all time high of $78-plus.

The powers that be at the latest OPEC meeting have just agreed to raise production quotas in a bid to keep crude prices stable, but the effort is expected to be a marginal solution, if that, for containing the ongoing bull market in oil. "The outlook is for the oil market to continue to tighten all the way through the fourth quarter and that's exactly what you are seeing reflected in the price," Kevin Norrish of Barclays Capital told Reuters on Wednesday. "What happened at the OPEC meeting doesn't alter that perception one bit. The [production] increase was relatively modest."

The implications of a slowing U.S. economy and oil prices that remain high are many, and not necessarily encouraging. One issue that arises is the prospect of the energy market exacerbating the economic slowdown. The odds of this risk may be rising to the extent that the U.S. economy is decoupling from the global economy.

Exhibit A in the decoupling argument is China's economy, which continued roaring higher by a real annualized 11.9% in the second quarter vs. 1.9% for the U.S. If China, and other "emerging markets" are increasingly driving the price of oil, a bull market in energy may prevail for longer than a U.S.-centric view suggests.

The possibility of oil prices staying high while U.S. growth weakens raises a number of challenges. We'll focus on one: the expected impact on inflation. The prevailing view at the Fed is that core measures of inflation (i.e., excluding food and energy) are superior for estimating future headline inflation. The basic idea is that rates of change in core and headline inflation eventually converge even though in the interim one index can deviate sharply from the other. But as a forecasting tool, core is said to be superior because it delivers a lower amount of statistical "noise" compared to headline. For those who accept this line of thinking, core measures of inflation of late offer support for the view that inflation's contained.

The main reason for rethinking the wisdom of core comes from the idea that the energy market's cyclical dynamic has changed. For much of the oil industry's history, energy prices have generally followed a boom-bust cycle with prices rising sharply followed by dramatic price declines. But in the 21st century, one school of thought argues that the boom-bust profile of energy markets has ended, or at least diminished substantially. If so, that raises doubts about using core inflation as a superior predictor of headline inflation over time. In other words, ignoring energy if it's now in a long-term uptrend suggests that headline inflation may now be superior over core for gauging the general direction of prices.

In fact, there's some evidence suggesting just that. In the past, core and headline inflation (measured by the relevant personal consumption expenditures indices), have deviated in the short term but eventually converged in recent five-year time frames. But the trend toward convergence seems to have faded lately. Simply put, higher headline inflation doesn't appear to be coming back in-line with lower core. If this continues - which it will if energy's in a long-term bull market - setting monetary policy by watching core inflation will underestimate inflation's trend by more than a little.

One can only wonder if Bernanke and company recognize the risk. Presumably, they do. The Fed, after all, draws on one of the largest economic research teams on the planet. If there's a trend in economics, someone at the central bank is documenting it. That said, the Fed's room to maneuver on monetary policy may be narrower than Wall Street realizes. A lot depends on how energy reacts to a slowing U.S. economy.