IN FOCUS6-8 min read

What might oil back above US$90 mean for inflation?

With the surging oil price making investors nervous ahead of September's highly anticipated US inflation figures, we look at the implications for the global economy.



George Brown
Senior US Economist

A little over a year ago, the annual rate of US Consumer Price Index (CPI) inflation stood at a four-decade high of around 9%. Today, it is just above 3%. This stark reversal has been largely due to the jump in energy prices unwinding in 2022. But output cuts by OPEC+ have seen oil prices rise by 20% over the past three months, with Brent crude back above US$90 per barrel for the first time since November 2022. This is in complete contrast to last summer, when recession fears drove prices down 20% over the same period.

Will the increase in energy costs be largely absorbed by business?

While energy is not directly included in core CPI, oil is an important intermediate input for goods and services. Consider the ubiquity of plastic, for instance, of which about 90% is created from fossil-based sources. As such, there will be some knock-on impact from rising oil prices to core inflation. And with core goods and services accounting for roughly 80% of the CPI basket, it is important to quantify what the impact is likely to be.

As there are no official figures on the commodity content of core CPI, we instead utilise estimates from Goldman Sachs. While their analysis suggests energy costs make-up as much as 15.9% of some categories, in aggregate they account for just 1.7% of overall core CPI.

Why so low? Partly because rents comprise such a large share of the price basket, but even excluding these makes little difference. Rather, it is mainly due to the prices charged by producers being diluted by wholesale and retail margins, which can often account for half or more of the prices paid by consumers.

Energy is a small share of core CPI prices and firms pass on less than half of increases

Businesses pass on energy costs

Still, margins are sometimes used to absorb higher energy costs. Goldman Sachs estimate that firms passed through 45% of rises before the pandemic, but this climbs to 60% when including data over the past three years. They ascribe the pick-up in the pass-through rate to lower competitive pressure amidst demand/supply imbalances and less willingness to absorb oil price increases due to broad-based cost pressures. After accounting for these, they estimate that the pass-through rate is in line with what it was before 2020 (i.e. 45%).

Putting this all together, we can assume that roughly half of the 20% rise in oil prices over the past three months will be passed on. And since energy prices account for 1.7% of core CPI, this suggests the total inflationary impact will be less than 0.2 percentage points. Given that this will be spread across several months, it should be barely perceptible.

Offshoring helped reduce impact of rising energy prices

Even the impact on headline inflation ought to be more muted than it has been in the past. This is because the energy intensity of the economy, which is calculated as total energy consumption divided by GDP, has fallen sharply over the past few decades. In 2022, it stood at 5.02 thousand British thermal units per US dollar, nearly 60% below what it was during the 1979 energy crisis.

There are two reasons for this. First, the relative efficiency of buildings, vehicles and industrial processes have improved over the decades. Technological progress has played a role here, but so have regulatory initiatives.

Secondly, the service sector accounts for a larger share of the economy after the offshoring of energy-intensive sectors. The US states of Oregon and Washington have witnessed a 50% decline in energy intensity over the past two decades. This has occurred after transitioning their economies from energy-intensive industries, such as forestry and agriculture, to less energy-intensive industries, such as electronics and information technology.

Continued tightness of US jobs market the key factor

However, the services sector is more labour-intensive than goods-producing sectors, for which capital can more easily be substituted. And so, while oil prices have risen sharply, investors should instead be more concerned by the continued tightness of the US jobs market. On one measure, the ratio of job openings to unemployment, it is the tightest seen since the late-1960s with 1.5 vacancies for every person out of work and looking for a job.

These strains are gradually easing, but they could well persist. There could, for instance, be some instances of labour hoarding, with firms being reluctant to lay off staff in the face of deteriorating economic conditions. While this is generally uncommon in the US, given the ease at which workers can be fired and re-hired, the hiring difficulties experienced over recent years may well cause a shift in behaviour among employers.

Excess demand for labour could keep wage growth elevated. While the Atlanta Fed wage tracker has rolled over, it suggests that pay is still growing at over 5% per annum. However, ultimately it is not wages, but unit labour costs adjusted for productivity which matter for both companies and inflation. Encouragingly, recent figures suggest that output per head is now returning to its pre-pandemic trend.

Ensuring that this is sustained is central to the soft-landing narrative playing out. The recent rise in business investment is certainly encouraging on this front, but capital expenditure does not always translate to productivity gains. And while advancements in artificial intelligence (AI) could in theory have multiple use cases, new technologies often take time to be deployed widely across the economy and so any material boost to productivity seems some way off.

So, while we expect US core CPI inflation to ease to 2.6% by the end of 2024, there is a risk that it could prove stickier. But it will be the labour market, not oil prices, which will determine whether this is the case.

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George Brown
Senior US Economist


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