August 23, 2016—For quite some time we have had an outlook for inflation that is higher than the market pricing. Much of the short-term outlook is based on our expectations for energy prices. Energy has been a significant drag on overall inflation since the collapse of crude oil in 2014–2015.

We are quickly approaching the time when energy prices are more likely to be adding to headline inflation instead of detracting. This is less the result of a resurgence in prices than from base effects of the low prices in late 2015 and early 2016.

First, a note about gasoline prices because that is the actual, relevant item in consumer prices that we all face at the pump. (Very few of us have ever purchased a barrel of oil.) The chart below shows the understandably tight relationship between crude oil prices and gas prices. There is a notable and well-documented lag, where movements in the price of crude oil are reflected in gas prices a week or two later. This is especially relevant in the very immediate term as crude has bounced 20% from the recent low of $40/barrel to about $48/barrel so far this week. Gas prices have only started to turn back up and are likely to keep moving up thanks to that lagged effect.


Source: Bloomberg

To understand the coming base effects, consider three scenarios. The medium scenario is the simplest assumption that prices remain unchanged from the most recent tick of $2.20 per gallon. The higher scenario (not really all that high) assumes a move up to $2.50 per gallon, and the low scenario is quite bearish with a sustained low price of $1.90. Of course none of these scenarios will come to fruition, but they are meant for illustrative purposes. Hopefully they appear fairly benign and reasonable.


Sources: Bloomberg; WTIA

The chart below shows the dramatic coming impact of the base effects in a year-over-year (y/y) calculation for the three scenarios. The gold line shows gas prices down 20% y/y in the most recent reading. In the medium scenario, that drag from gas prices would be reduced to just -5% by the end of September and would cease to be a drag at all by the beginning of November. In November and December of 2016, gas prices would be additive to headline inflation with the peak coming in February 2017, up nearly 30% y/y. The high scenario results in a positive y/y gas price before the end September, just a month from now. They would be up 25% y/y in December, and then peak at 45% y/y in February 2017. And of course the calculations would be higher if gasoline goes higher than $2.50 per gallon.


Sources: Bloomberg; WTIA

How will this affect inflation?
Headline inflation has been very low since the energy price collapse, at around zero for most of 2015 and 1% through most of 2016. As we’ve discussed, core CPI inflation (removing the impact of the more volatile energy and food prices) accelerated in 2015; the most recent reading was 2.2% y/y. Once the impact of gasoline goes to zero (which happens at different times in the three scenarios) headline CPI inflation should be essentially the same as core CPI, so just over 2%. If and when gas prices turn positive in y/y terms (as early as October in the high scenario), we would start to see headline inflation above 2.5% and then could easily move closer to 3% if either the high or medium scenario plays out.


Source: Bureau of Labor Statistics

Core narrative
This outlook on oil and gasoline prices, and the impact on inflation, has been a key part of our core narrative for quite some time. The very recent bounce in oil prices (after a worrisome decline in July) is encouraging and supportive of our view. Of course it could turn back around, but as we have argued in earlier posts, the fundamentals of the oil market point to higher prices, not lower.

This is not to say we should fear runaway inflation. Just as we (and the Fed) viewed the impacts of energy prices as transitory on the way down and did not expect 0% inflation to persist or turn into deflation, we also don’t expect this reversal to signal rampant future inflation. But we should still be conscious of the possible impacts on markets. Nominal Treasury yields and Treasury inflation-protected securities (TIPS) breakevens are of course sensitive to inflation readings and expectations of future inflation. And higher headline inflation figures have the potential to spook investors about prospective Fed policy. I would expect the Fed to be encouraged by higher inflation figures, not the transitory nature of energy price impacts, and stress the need to focus on the core measures of underlying inflation.


Wilmington Trust is a registered service mark. Wilmington Trust Corporation is a wholly owned subsidiary of M&T Bank Corporation. Investment management and fiduciary services are provided by Wilmington Trust Company, operating in Delaware only, and Wilmington Trust, N.A., a national bank. Loans, retail and business deposits, and other personal and business banking services and products are offered by Manufacturers and Traders Trust Company (M&T Bank), member FDIC. Wilmington Trust Investment Advisors, Inc., a subsidiary of M&T Bank, is a SEC-registered investment adviser providing investment management services to Wilmington Trust and M&T affiliates and clients.

These materials are based on public information. Facts and views presented in this report have not been reviewed by, and may not reflect information known to, professionals in other business areas of Wilmington Trust or M&T Bank who may provide or seek to provide financial services to entities referred to in this report. M&T Bank and Wilmington Trust have established information barriers between their various business groups. As a result, M&T Bank and Wilmington Trust do not disclose certain client relationships with, or compensation received from, such entities in their reports.

The information on Wilmington Wire has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates, and projections constitute the judgment of Wilmington Trust and are subject to change without notice. This commentary is for information purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or a recommendation or determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on the investor’s objectives, financial situation, and particular needs. Diversification does not ensure a profit or guarantee against a loss. There is no assurance that any investment strategy will succeed.

Any investment products discussed in this commentary are not insured by the FDIC or any other governmental agency, are not deposits of or other obligations of or guaranteed by M&T Bank, Wilmington Trust, or any other bank or entity, and are subject to risks, including a possible loss of the principal amount invested. Some investment products may be available only to certain “qualified investors”—that is, investors who meet certain income and/or investable assets thresholds. Past performance is no guarantee of future results. Investing involves risk and you may incur a profit or a loss.

Any positioning information provided does not include all positions that were taken in client accounts and may not be representative of current positioning. It should not be assumed that the positions described are or will be profitable or that positions taken in the future will be profitable or will equal the performance of those described. Positions described are illustrative and not intended as a recommendation outside of a managed account.

Indices are not available for direct investment. Investment in a security or strategy designed to replicate the performance of an index will incur expenses, such as management fees and transaction costs that would reduce returns.

Third party trademarks and brands are the property of their respective owners.

Contact an Expert