Tighter monetary conditions – not lower oil prices - are pushing down inflation expectations
Oil prices are tumbling and so are inflation expectations so it is only natural to conclude that the drop in inflation expectations is caused by a positive supply shock – lower oil prices. However, that is not necessarily the case. In fact I believe it is wrong. Let me explain. If for example 2-year/2-year euro zone inflation expectations drop now because of lower oil prices then it cannot be because of lower oil prices now, but rather because of expectations for lower oil prices in the future. But the market is not expecting lower oil prices (or lower commodity prices in general) in the future. In fact the oil futures market expects oil prices to rise going forward. Just take a look at the so-called 1-year forward premium for brent oil. This is the expected increase in oil prices over the next year as priced by the forward market. Oil prices have now dropped so much that market participants now actually expect rising oil prices over the going year. Hence, we cannot justify lower inflation expectations by pointing to expectations for lower oil prices - because the market actual expects higher oil prices - more than 2.5% higher oil prices over the coming year. So it is not primarily a positive supply shock we are seeing playing out right now. Rather it is primarily a negative demand shock – tighter monetary conditions. Who is tightening? Well, everybody -The Fed has signalled rate hikes next year, the ECB is continuing to failing to deliver on QE, the BoJ is allowing the strengthening of the yen to continue and the PBoC is allowing nominal demand growth to continue to slow. As a result the world is once again becoming increasingly deflationary and that might also be the real reason why we are seeing lower commodity prices right now. Furthermore, if we were indeed primarily seeing a positive supply shock – rather than tighter global monetary conditions – then global stock prices would have been up and not down. I can understand the confusion. It is hard to differentiate between supply and demand shocks, but we should never reason from a price change and Scott Sumner is therefore totally correct when he is saying that we need a NGDP futures market as such a market would give us a direct and very good indicator of whether monetary/demand conditions are tightening or not. Unfortunately we do not have such a market and there is therefore the risk that central banks around the world will claim that the drop in inflation expectations is driven by supply factors and that they therefore don’t have to react to it, while in fact global monetary conditions once again are tightening. We have seen it over and over again in the past six years – monetary policy failure happens when central bankers fail to differentiate properly between supply and demand shocks. Hopefully this time they will realized the mistake before things get too bad. PS I am not arguing that the drop in actual inflation right now is not caused by lower oil prices. I am claiming that lower inflation expectations are not caused by an expectation of lower oil prices in the future. PPS This post was greatly inspired by clever young colleague Jens Pedersen.