Han Dieperink: An oil shock does not necessarily lead to inflation
This column was originally written in Dutch. This is an English translation.
By Han Dieperink, written in a personal capacity
There is a strong likelihood that the oil shock resulting from the war in Iran will ultimately have a deflationary effect. That may seem strange. Surely a sharp rise in oil prices leads to higher inflation?
At first glance, that assumption seems correct. Energy is a component of almost every product and service. Higher oil prices make transport, manufacturing and heating more expensive. Consumers notice this immediately at the pump and on their energy bills. Yet this is only half the story. And it isn’t even the most important half.
An oil shock acts like a tax increase in the economy. The difference is that the revenue does not go to the home government, but to oil-producing countries. Consumers’ purchasing power falls. Households that spend more on energy spend less on other products and services. Companies see their profits fall or are forced to raise their prices, causing demand to fall further. In the medium term, an oil shock thus leads to lower growth, lower consumption and lower investment. That is a deflationary impulse.
The visibility of the oil price distorts the picture
Few prices are as visible as those of fuel. In almost every country, the price per litre is displayed in large figures along the roadside. In the United States, a rise above four dollars per gallon is presented as a national crisis. But that visibility distorts the picture. Relative prices are constantly shifting with supply and demand. In the US, a gallon of petrol today buys you about twenty eggs; a year ago, that figure was just six. The price of petrol has risen, but the price of eggs has fallen even more sharply. Anyone who looks only at the petrol pump misses the broader context.
More importantly, consumers are adjusting their behaviour in response to higher fuel prices, and this reinforces the deflationary effect. In the United Kingdom, demand for motor fuel remains 3.5% below pre-pandemic levels. This is partly due to more fuel-efficient cars and electric vehicles, but Britons are also actually driving less than in 2019. In the United States, fuel volumes are at pre-pandemic levels, but below those of 2015. The picture is similar in Germany and France. Consumers are adapting. The political tendency to subsidise fuel rather than letting the price mechanism do its work actually undermines that adaptability. Governments wishing to ease the pain would do better to offer targeted income support rather than keeping fuel prices artificially low.
The 1970s are often cited as proof that oil shocks fuel inflation. But a closer look reveals that it was not the oil shock itself that caused inflation. It was the monetary policy that followed. Central banks, led by the Federal Reserve, chose to pursue an expansionary monetary policy and keep interest rates low. The money that flooded into the economy as a result fuelled a wage-price spiral. This caused inflation to rise into double figures. It was not oil that caused this. It was the money.
Inflation is always and everywhere a monetary phenomenon
According to Milton Friedman, inflation is always and everywhere a monetary phenomenon. A higher oil price is a shift in relative prices. Oil becomes more expensive relative to other goods. Without an increase in the money supply, consumers must offset the higher expenditure on energy with lower expenditure elsewhere. Some prices rise, others fall, and the general price level remains on balance the same or even falls. Only when central banks expand the money supply to ease the pain of higher energy prices does the general price level rise. It is not the oil shock that causes inflation, but the monetary policy response.
That is what makes the stance of central banks during this oil shock so important. As long as the Federal Reserve and the European Central Bank stick to their inflation targets and refuse to cushion the shock with looser policy, the higher oil price will ultimately have a deflationary effect. Higher energy costs destroy demand, slow growth and suppress underlying inflation. The central bank need do nothing other than remain steadfast. That does, however, require political courage. In the short term, prices rise and the economy contracts. The temptation to intervene with lower interest rates is great. But anyone who gives in to that temptation repeats the mistake of the 1970s.
Artificial intelligence structurally reinforces deflationary pressures
Added to this is a structural force that is altering the inflation outlook in the longer term. Artificial intelligence reduces the costs of knowledge, services and production in a way that is still underestimated. The productivity gains delivered by AI translate into lower prices for software, consultancy, customer service, logistics and research. Previous technological revolutions (the steam engine, electricity, the internet) took decades to achieve their price-depressing effect. The adoption of AI is proceeding many times faster. The deflationary pressure from AI is structural, not temporary, and amplifies the effect of a fall in demand following an oil shock.
The combination of these two forces points in one direction: an oil shock that destroys demand in the medium term and a technological revolution that structurally reduces costs. Inflation risks are overestimated, while deflation risks are underestimated. This is all the more true in a world where the energy intensity of the economy has fallen by more than half over the past fifty years and where consumers demonstrably use less fuel than they did ten years ago. The impact of an oil shock is therefore much smaller than it was in the 1970s.
Implications for investors: quality shares and bonds as a hedge
This has significant implications for investors. An oil shock leads to short-term market volatility, but it is no reason to sell risky investments. If central banks show discipline, the situation will resolve itself. Quality shares, private equity and property will then benefit from the lower interest rates that follow the economic slowdown. In that scenario, bonds do offer protection, precisely because expected inflation ultimately falls. Conversely, those who position themselves for prolonged high inflation are effectively betting on policy errors by central banks.
An oil shock is not an inflationary event. It is a test of monetary policy. Central banks that stand firm allow deflationary forces to run their course. Central banks that succumb create the very inflation they claim to be fighting. Inflation is always and everywhere a monetary phenomenon. This applies no less to an oil shock than to any other shock.