At least Katrina’s dark legacy will eventually fade. Energy is another matter for the simple reason that the bull market in oil may still have legs. If more of the same is coming in the pricing of crude, the trend will eventually squeeze the economy to a degree that’s more noticeable, and for the worse.

That starts with inflation. Higher oil prices stoke higher inflation. That’s a byproduct of the fact that oil is directly or indirectly tied in varying degrees to much of what America produces in goods and services. It’s also a key cost in transporting goods, not to mention people. Oil’s also a component in the manufacture of items that you wouldn’t immediately connect with energy. Indeed, petroleum-based products can be found in a range of items from medicines to plastics.
Accordingly, businesses have a hard to avoid getting hit with the higher cost of operation when oil prices rise. Business people, being an intelligent and logical race of creature, try to pass any additional costs on to consumers, thereby laying the groundwork for higher prices generally. The key here is that the higher prices aren’t driven by higher demand; rather, the higher prices are a function of the bull market in energy. Translation: inflation can find fertile ground in the latter form of price hikes.
It’s happened before (as a quick review of the 1970s will confirm), and it may be happening again, albeit in a nascent state. So far, at least, we’re a long way off from the inflationary fires that burned in the seventies. But raging infernos can start with a single match. To be sure, there are both inflationary and deflationary forces blowing in the global economy. Deciding which one will triumph over time is at once pressing and difficult. But one will eventually win, and perhaps sooner rather than later.
In that task of diving the future, doomed or not, we can start by looking at the past. The nature of the current inflation, such as it is, appears to be driven by energy. Consider the producer price index. Measured sans food and energy, PPI’s year-over-year advance in July was 2.8%. Add food and energy back into the mix and the annual rise jumps to 4.6%. A similar trend is visible in consumer prices: CPI ex-food and energy increased 2.1% on the year through July vs. 3.2% when the index is calculated with food and energy prices.
Is more of the same on tap for tomorrow, September 13, when the August CPI and PPI numbers are released? Absolutely, or so the consensus forecast suggests. PPI for August (scheduled for release tomorrow, September 13) is expected to rise 0.7%, while PPI ex-food and energy will advance by just 0.1%, according to estimates compiled by Briefing.com.
The fact that energy is the force pushing inflation higher is both a blessing and a curse. A blessing in that we know where the inflationary momentum lies. As such, we can surmise that inflation may yet be contained if energy prices fall. If energy is the reason for inflation’s ascendancy, energy can also be its slayer, if oil prices retreat. Today, at least, there was reason to hope for such an outcome. A barrel of crude fell 1.2% today in New York futures trading, closing at around $63.3, the lowest in nearly a month.
But one day a trend doesn’t make. As news of the Gulf of Mexico’s rebuilding gathers attention, the opportunity for a near-term pullback in energy prices looks promising. As traders cash in on the recent price surge tied to Hurricane Katrina, there’s reason to think that renewed efforts to boost supply by any means possible could affect short-term sentiment.
In turn, a sustained fall in oil prices could soon pare the inflation rate. Then again, so too could an economic slowdown. Indeed, today’s sharp drop in oil prices is said by some to reflect a downshifting in the U.S. economy. “For the first time, traders have to worry about demand,” Gary Ross, chief executive of U.S. energy consultancy PIRA Energy, tells Reuters today. “There’s no doubt there is evidence of demand destruction emerging everywhere. U.S. gasoline data over the next few weeks will show the effect of high oil prices on demand.”
Thorsten Fischer, senior economist at Economy.com, tells TheStreet.com advances a similar notion, predicting that “there will be a reduction in economic activity in the second half of this year, in part because of high energy prices.”
But once again, there’s a spirited debate on the issue. The gold market, for one, begs to differ, or so one could argue. The price of the precious metal forged higher for a time again today, pushing north of $450 an ounce for the first time since last December. “Rising energy prices raise concern over inflation, which will drive gold prices higher as investors buy the metal as an anti-inflationary hedge,” James Moore, a metals analyst at TheBullionDesk.com, tells Bloomberg News today.
The markets will eventually have to sort out whether high oil prices promote inflation or recession. It can’t be both.
Meanwhile, the yield on the 10-year Treasury Note rose to about 4.18% in sympathy with gold. That’s the highest yield since August 26, a few days before Katrina hit the Gulf coast. Bond traders are worried that with oil prices falling, the Fed may feel less political pressure, born of Katrina, to halt its recent round of interest-rate hikes, which may be inflationary if, as some assert, the Fed’s monetary policy is still too loose.
There are as many theories about where interest rates, gold, inflation, and the economy are headed as there are traders on Wall Street. But no matter your view of the global economy, and the rules that govern it, energy may still be the closest thing to an advance notice on what lies ahead for those markets. Now if we could just figure out where the price of oil is headed, and what the price change means, we could pick the winners and losers with absolute precision. Meantime, until value rears its pretty little head, speculating is the only game in town. Step right up and place your bets!