Oil price rally driving US inflation expectations

Oil prices have been on a rollercoaster ride over the last several years. After averaging $100-plus per barrel from mid-2013 through mid-2014, West Texas Intermediate prices fell as low as $29 per barrel this past February. 

Since then, prices have recovered sharply, having averaged over $50 per barrel thus far in December. The recent OPEC gathering in Vienna has the potential to reduce future supply even more; in response, oil prices have recently flirted with the mid-50s. 

{mosads}What does this tell us about the economy and broader financial markets, in particular, the U.S. government bond market?

First of all, the near doubling of oil prices from earlier this year bodes well for future energy investment, which had been in freefall following its decline from the 2013 to 2014 highs. 

In point of fact, energy-related capital outlays are down nearly 70 percent from their recent peak. This has had a severe negative impact on overall GDP growth, corporate profits and hiring. 

The recovery in oil prices should help reverse some of these trends. Already, investors’ expectations of sharply higher energy-sector related earnings have helped boost the overall stock market. 

Since the election, energy stocks are up over 11 percent, which is nearly double the 6 percent increase in the broader equity market over the same time. However, the impact has not been limited only to stocks. Rising oil prices have also been felt in the bond market, where inflation expectations have been on the rise.

Even though energy has only a 7 percent weight in the consumer price index (CPI) — the most popular measure of inflation — price changes in the former can be so large that they have a meaningful impact on inflation. 

We see this in the very high correlation between monthly changes in energy prices and the headline CPI — it is a remarkable 0.96. Take the recent CPI report for October. 

Energy prices increased a significant 3.5 percent in the month. Indeed, it was the biggest monthly gain since February 2015. 

Not surprisingly, the jump in energy prices coincided with a significantly above-trend increase in the headline CPI which increased a large 0.4%. 

If oil prices remain elevated, the recent increase in interest rates is unlikely to reverse. And, if oil prices were to rise further, interest rates would almost surely move even higher. 

We can see how much interest rates have increased already because of higher oil prices.

Based on the expected rate of inflation that can be inferred from Treasury Inflation Protected Securities, or TIPS, the inflation rate is poised to average around 2 percent over the next decade. 

At least this is what the market believes. Earlier this summer, the yield on 10-year TIPS was only around 1.50 percent. 

Higher oil prices have helped push interest rates higher. But another factor has recently exerted upward pressure on interest rates. 

That is the high likelihood of meaningful fiscal stimulus under President-elect Trump. In fact, some of the increase in TIPS probably also reflects higher inflation that would be result from stronger economic activity. 

No doubt, higher interest rates will lift interest costs for both businesses and consumers. However, the expected improvement in corporate profits and personal income that would accompany faster growth would help defray higher interest costs. 

Joseph LaVorgna is the Managing Director and Chief U.S. Economist for Deutsche Bank.

The views expressed by Contributors are their own and not the views of The Hill.