From crude to CPI: how oil swings shape inflation and rates

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SIMON BROWN: I’m chatting with Old Mutual Wealth investment strategist Izak Odendaal. Izac, appreciate the time. I was going to say it’s been a wild week for oil. It’s been a wild year. I’m reminded that we started the year around $60/barrel for Brent. We hit almost $120 on Monday. It has come back. Who knows where it’ll go?

I want to touch on oil and inflation first. In a recent note you mentioned that a $10 movement in the oil price is about 0.4% of inflation.

IZAK ODENDAAL: Yes, that is the  sort of rule of thumb internationally, which suggests that if the oil price has gone up $20 or $30/barrel, that adds an additional maybe 1% to inflation over and above what we would have expected this year. But, importantly, that is just the temporary immediate impact and not necessarily what is going to matter in terms of long- term market movements or how central banks respond.

To put it differently, if the oil price goes up from $60, as you mentioned, all the way to $100/barrel, but stays at $100 for 12 months, then oil is still going to be ridiculously expensive, but after 12 months the inflation rate, the year-on-year inflation rate, falls down to zero. In other words, the immediate impact of oil prices on inflation is temporary.

SIMON BROWN: So central banks – next week we’ve the FOMC [Federal Open Market Committee] meeting. Then we’ve our own MPC [Monetary Policy Committee] meeting the week after that. Is that the view that they will take? In other words, let’s be a little cautious. Yes, we might have some inflation coming, but it’s not a demand-driven issue at all and it will work its way through the system.

IZAK ODENDAAL: Absolutely. It’s not a demand-driven situation. This is absolutely a supply shock. They can’t do anything about it. They can’t go and look for their own oil anywhere. They can’t open the Strait of Hormuz. So what they’re going to do is they’re just going to monitor the situation.

Of course, what they care about is the so-called second-round effect, which is do other companies use higher input costs from oil and fuel to raise their prices? To put it very simply, if [the companies consider] that they must transport goods all over the country from warehouse to store, do they increase the price of milk and chocolates and baby food because diesel costs have gone up?

If the answer is yes, then we have a second-round effect, and the Reserve Bank starts becoming interested. If the answer is no, then it can look through this event.

I think that’s also where [the Sarb] will argue that inflation expectations matter because, if people believe that ultimately inflation returns to 3% – ‘people’ being both consumers and businesses – then again this can be a temporary shock. Everyone understands it’s going to be temporary and understands that things will get back to around 3%. And then, once again, there’s no need to raise interest rates in response to higher CPI [Consumer Price Index] numbers.

SIMON BROWN: Yes. What we do have, as I said, is that with our MPC announcement on 29 January, it was widely expected that they would cut another 25 points. That must surely be off the table – just out of an abundance of caution though.

IZAK ODENDAAL: Correct, yes. They’re not going to move in this kind of environment with the rand jumping around as much as it is, with so much uncertainty internationally and [not knowing] how the war is going to play out. So yes, I think central banks everywhere, including the Fed, will probably just sit still for now, and then we’ll see.

I think if things settle down in the Gulf – and again, nobody knows – but if things settle down and the oil price pulls back to somewhere in the $70/80s, I think that’s not a crisis level and ultimately petrol prices will stabilise again. I think then we can talk about the resumption of the rate-cutting cycle in South Africa.

Of course in the US it’s a different story because they, unlike South Africa where inflation has been low, they have had sticky inflation over the last couple of months. They were going to be in a bit of a dilemma anyway, because you have stickiness in the inflation rate plus you have what seems to be a very soft labour market. So their dual mandate was already being pulled in different directions.

Of course they’re getting a new chairman, so all kinds of complications for the Fed.

SIMON BROWN: Our MPC I suppose in some sense has an easier job. It is that Fed. If we go back to Jackson Hole last year, Jerome Powell’s speech there, he did seem to suggest he was erring on the side of jobs and therefore focusing on that. But of course he hadn’t anticipated a potential threat to inflation. It really does put them in the classic ‘between a rock and a hard place’ situation, which then almost suggests the easy move is to sit in your hands.

IZAK ODENDAAL: Yes, I think I think the natural response is going to be to sit and wait – and then assess how it plays out. Again, during the course of the year, maybe the second half of the year, things will have calmed down. Maybe they will have more confidence to ease.

Again, if they have to choose between the labour market and inflation at this stage of the game, I think they will focus on the labour market. The inflation is elevated, so it’s uncomfortable for them, but I think ultimately they will probably say that the bigger risk here is that we have a rise in the unemployment rate. And so from that point of view I would imagine that rate cuts later this year are still on the cards, provided that the conflict subsides, the Strait of Hormuz opens up, and oil prices stabilise somewhat – and that’s a big ‘if’. We simply don’t know how that that is playing out.

SIMON BROWN: I take that point, 100%. We have no idea how it’s going to play out.

We’ll leave it there. Izak Odendaal, Old Mutual Wealth investment strategist, I appreciate the time.

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