Oil continued its rise for a third week, with the global Brent crude benchmark nearing $110 per barrel as of Wednesday afternoon.
This energy shock threatens another bout of inflation and demand destruction that will prove instructive in understanding how the American consumer perceives affordability.
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The Federal Reserve’s Summary of Economic Projections came with an overriding dose of uncertainty. Its latest projections accompanied the Federal Open Market Committee’s decision to maintain its policy rate within a range of 3.50% to 3.75%, despite an increase in the FOMC’s median expectations for stronger economic growth and inflation rates remaining considerably above its 2% target.
The SEP estimates now have the personal consumption expenditures index inflation rate increasing in the fourth quarter to 2.7%, with core PCE inflation, which excludes food and energy, also increasing to 2.7%.
The range of projections for the PCE inflation rate was between 2.3% and 3.3% for the top-line rate, and 2.2% and 3.0% for the core measure, both ranges higher than the committee’s previous estimates at its December meeting.
We are anticipating the top-line inflation rate to increase to between 3.5% and 4%, which will carry with it second- and third-order effects that will be transmitted down to the household over the next six months even if the conflict ends soon.
Our baseline when it comes to inflation and the American household since the pandemic has been food, fuel and utilities.
Those prices are either increasing now, as with the cost of fuel, or soon will, as with food and utilities. While we do not think that the current price of oil will result in wholesale demand destruction sufficient to cause a recession, it will create a drag on growth and another downturn in consumer and corporate sentiment.
State of play
Households are focusing on inflation as the cost of gasoline rises at the pump and travel costs increase along with it.
This is on top of a micro shock that is occurring across the global food chain because of exposure to nitrogen fertilizers as well as other petrochemicals that feed into metals and tech supply chains. The result will be higher prices for many essential consumer goods.
We will experience at the very least a short-term affordability shock that will restrain consumption and growth. Even if it does not cause an end to the business cycle, it will take a toll on the economy.
Should oil prices remain elevated, it will be appropriate to discuss risks around a recession, and how the energy shock will be felt across the economy.
First-order effect: Energy prices
The first-order effect of the energy crisis is the increase in energy prices. By the time oil shipments out of the Mideast were halted, households in the U.S. were already competing with the increased demand for electricity from data centers, even as gasoline prices were moderating.
The rise in the price of crude oil has pushed up the cost of gasoline by nearly a dollar a gallon on average, from $2.80 in January to $3.79 in March.
Second-order effect: Intermediate goods
The second-order effect is the increased cost of intermediate goods, including the cost of transportation, whether by ocean shipping or trucking or by airline fares that raise the cost of doing business and household recreation.
Every product ends up on a truck at some point and either the owner or the customer eats the increased cost. This goes for restaurants, clothing stores, grocery stores and the manufacturers that end up paying for materials shipped to the U.S. on a boat or delivered domestically by a truck.
There are numerous examples beyond the cost of driving your car.
The cost of bunker fuel that powers ocean shipping has increased by 21% since January on a weighted average basis as measured by Bloomberg; the Singapore spot price has surged by 164%.
The cost of aluminum has increased by 17% this year. And the diminished supply of helium, which is a byproduct of liquified natural gas with Qatar producing a third of the global supply, will have a knock-on effect on the production of computer chips.
Third-order effect: Food
The third-order effect is the human cost that the shortage of petroleum-based fertilizer imposes on global and local populations. Petroleum-based fertilizers release nitrogen into the soil, increasing crop yields. A shortage of petroleum will raise the cost of fertilizers, leading to possible shortfalls of food, whether it comes from Pennsylvania or Ukraine.
While food’s increased price is felt in high-income households, it is devastating for poorer communities.
And while the U.S. has over the years tried to ameliorate the effects of energy shortages, neither the restriction imposed during the 1970s oil embargoes or the more recent petroleum reserve releases have worked out all that well.
Measuring affordability
Although delayed by a month, data inside the February consumer price index—collected before the war began—shows what households were already facing.
Outside of rents, which account for 35% of the total expense categories tracked by the CPI, daily household attention is focused on the cost of food, which has a 14% weight in the CPI, and energy, which has a 6% weight.
While the overall inflation rate has stayed at 2.4% in January and February, when the cost of coffee explodes by 25% in the months since the tariffs were imposed last April, or a head of romaine lettuce climbs by 22%, people take notice.
It is costing households 7.6% more to cook their food or heat their home with natural gas and 4.4% more for electricity as demand from data centers competes for supply.
This lack of affordability comes after 15 years of improved efficiency in the global supply chain. These pricing dynamics are not lost on households, which explains why they sense an affordability crisis is underway.
The takeaway
We do not expect the current 2.4% rate of inflation to stick. We anticipate a sharp jump in the CPI to at least 3.5% over the next two months.
The first- and second-order effects of an energy crisis are energy costs and the availability and prices of intermediate goods. The third-order effect is a global shortage of food as increased fertilizer costs lead to reduced crop yields.
Policymakers, economists and strategists must be forthright about how the oil and energy shocks will affect consumers.
Downplaying the risks at a time when the public senses an intensification of an already challenging affordability crisis is a recipe for inflation expectations to become unanchored, which will create the conditions for another persistent and potentially destabilizing round of inflation.
