Oil will quickly change the inflation landscape

The Eurozone risks getting stuck in a deflationary trap. Well, at least that’s what the President of the European Central Bank, Mr. Draghi, keeps telling us. Eurozone inflation numbers, which have flirted with deflation for over two years now, show he does have a point. The financial crisis left the world with lots of spare capacity and a massive debt overhang. Both of which have deflationary effects. Hence, to prevent these deflationary pressures from becoming entangled in inflation expectations, the ECB launched a massive bond-buying program.

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Using quantitative easing to fight low inflation is debatable, which makes it even more interesting that the inflation landscape will start to change quickly due to a factor that has little to do with QE, oil. The chart below shows that Eurozone headline inflation numbers are heavily impacted by year-on-year changes in Brent oil. The more pronounced the change in the price of oil, the more it shows up in the headline inflation number. The right part of the graph below displays the future year-on-year changes in the price of Brent oil for three price scenarios; Brent stable at USD 40, Brent stable at its current price of USD 51 and Brent stable at USD 60.

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In each of these scenarios the year-on-year change in the price of oil spikes in the coming months due to base effects. If headline inflation was perfectly correlated with Brent, which is obviously not the case, it would rise to 3% if Brent stays at USD 51. While it’s pretty safe to state it won’t make it up there, the direction is very clear. Even if Brent falls back to 40 USD, inflation is bound to pick up significantly between now and February.

For Mr. Draghi, however, it’s all about inflation expectations. Interestingly, however, they too are heavily influenced by the year-on-year change in the price of Brent oil. And not just short-term inflation expectations. The 5-year inflation swap is strongly correlated with the change in oil prices, even though the current year-on-year change has potentially nothing to do with inflation five years from now. Nevertheless, the chart below suggests that markets do not look through year-on—year changes in oil prices and that inflation expectations will shoot up in coming months.

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The notion that markets do not seem to anticipate the change in oil prices is further underpinned by the fact that the relative performance of inflation-linked Eurozone government bonds over nominal bonds is also correlated with year-on-year changes in oil prices.

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Hence, how do central banks, and markets, look at inflation just a couple of months from now? When Eurozone headline inflation has quadrupled to 1.6%, or higher. When the 5-year inflation swap has almost doubled as the change in oil price peaks. By that time, Chinese producer prices are probably up a little bit more as well, as are US wages, and UK inflation will definitely be heading for 3%. In addition, while headline inflation falls back after February, unless oil prices continue to rise, it would require another 50% price decline to push inflation (expectations) levels back to where they have been for the past couple of years. By February, inflation data will look much less deflationary than currently, just two months after the ECB announced an extension of its QE-program.

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