Rising crude oil prices bode well for the US dollar

BY DEB SHAW | 

  • Inflation has disappointed in 2017, but that looks set to change
  • Looking at crude oil prices in Q3 and beyond is helpful in predicting future inflation
  • Dollar looks set to strengthen in rising growth + rising inflation environment

Earlier today, the Australian dollar fell sharply following economic data showing lower-than-expected Consumer Price Index figures. While the average estimate for year-over-year CPI was 2%, the actual figure was 1.8%. Looking at CPI figures from around the world, inflation has disappointed despite strong economic growth throughout 2017. Janet Yellen, the Chair of the US Federal Reserve, recently remarked that the Fed’s framework for understanding inflation could be off “in some fundamental way”. She was alluding to the perplexing status quo of an improving economy coupled with lackluster inflation. While Yellen may be frustrated by low inflation for much of 2017, we argue that good news is likely to be around the corner.

Historical CPI figures for select developed economies are shown below. The UK is excluded due to import-fueled inflation as a result of Brexit. Japan is also excluded as Japanese CPI figures for Q3 2017 have yet to be announced.

Will inflation keep falling in the near future?

10-25-2017 global inflation
Source: Bureau of Labor Statistics, Eurostat, Statistics Canada, Australian Bureau of Statistics

 

Looking at the graph above, one can clearly see that CPI figures around the world move in tandem. In most countries, inflation strengthened in 2016 and peaked in Q1 2017. Since then, inflation rates have been falling in Q2 and Q3 2017. In particular, we would argue that inflation is especially sensitive to crude oil prices. Crude oil prices are shown below reference.

Crude oil prices are useful in predicting inflation

10-25-2017 WTI prices

 

Looking at the graph above, WTI bottomed below $30 in Q1 2016 and rose thereafter. As crude oil rose from its lows in Q1 2016, higher prices worked their way into the real economy. This caused CPI readings to accelerate in rate-of-change terms. CPI figures were especially high in the latter half of 2016 due to low base effects. That is, inflation looked high in annual rate-of-change terms because it was so much lower at the start of the year.

After CPI rates peaked globally in Q1 2017, they have been trending down throughout 2017. Once again, looking at recent crude oil prices is valuable. Crude oil prices peaked most recently between Q1 and Q2 2017 around $55 and fell below $45 at the end of Q2 2017. Lower crude oil prices have been felt in the real economy, with CPI figures falling in rate-of-change terms between Q1 2017 and today.

 

What’s next for inflation?

In predicting the future direction of inflation, crude oil prices are instructive. The commodity weakened down to its most recent bottom below $45 in Q2 2017. Following the combined impact of the hurricanes in the US and OPEC supply cuts, prices are now marching higher. Today, WTI is changing hands for around $53 per barrel. Given the significance of crude oil in the broader economy, higher prices should eventually work their way into prices tracked by CPI figures. In a recent commentary assessing crude oil market dynamics, we argued that crude is likely to head even higher in 2017, given relatively subdued supply.  

Assuming the historical relationship between crude oil and inflation remains intact, CPI figures are likely to change direction and starting heading higher over the coming quarters. Despite Yellen’s ongoing frustration and today’s inflation figures from Australia, low inflation is not going to linger forever.   

 

Accelerating inflation + accelerating growth = stronger dollar

As US GDP growth rates remain on an accelerating trend (see select developed economy growth rates below), a change in the trajectory of inflation will cause the US dollar to strengthen. This is because the Fed is much more likely to hike interest rates when both growth and inflation are accelerating. This year, the Fed has hiked rates in an environment of decelerating inflation (calling low inflation “transitory”). Once CPI readings accelerate in Q4 2017 and beyond, it should have no qualms hiking interest rates.

Up, up and away: global growth remains strong in 2017

10-25-2017 global growth
Source: US Bureau of Economic Analysis, Eurostat, JP Cabinet Office, Statistics Canada, Australian Bureau of Statistics

 

Topics: Crude oil, US dollar