The Impact of Interest Rates on Inflation and Oil Prices

As far as the formation of oil prices is concerned, it is chiefly irrelevant whether inflation has a tangible impact on oil prices or vice versa. What is important is that inflation and the occasional fight against it are among the many factors that investors consider when forecasting the price of oil. The relationship between the two is not always conspicuous, but as the chart above shows, they moved in tandem for the best part of the last four to five years. First, the pandemic-induced devastation obliterated oil demand, resulting in a considerable decrease in the price of WTI and a disappearing inflationary pressure. The post-Covid-19 recovery, followed by the outbreak of the Ukrainian War, reversed this trend. Positive demand shock and negative supply shock pushed consumer and oil prices higher. Central banks swung into action and by considerably raising the cost of borrowing they intended, rather successfully, to dampen aggregate demand, which inevitably impacted the price of oil.

The general view currently is that the increase of interest rates has been restrictive enough to slow down growth but not to cause recession. So, the question is whether the relationship between inflation and oil prices will persist this year and possibly beyond as the Federal Reserve has begun to contemplate lowering benchmark rates. The answer is probably yes. The U.S. central bank was the trailblazer in raising interest rates, and it is likely to be the first to start cutting them; the U.S. economy is on a much more solid footing than its peers. It will lead to an even more auspicious economic backdrop and a weaker dollar. Consumer and producer price growth is expected to stabilize and perhaps even increase moderately in light of the resolute economic outlook, and this, coupled with the weakening greenback, will provide the basis for resilient U.S. oil consumption. Amongst the several factors that impact the oil balance and prices, inflation is likely to become supportive when the Fed decides to lower the cost of borrowing.

All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.

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