How do current oil prices change our inflation forecast?

Despite this not being the 1970s, expectations of further disinflation will be impacted by higher oil prices. This could result in a slower decline of inflation to 2%. Given that our expectations for oil prices do include a drop in the first half of 2024 again, the effect on our own forecast is rather moderate. Plus, a smaller decline in energy prices has materialised this year compared to expectations (which impacts next year’s base effects).

Assuming oil prices stay at 95 USD/b for all of 2024, however, the headline figure would rise by 0.3 pp next year, with a peak of the energy price contribution of 1 ppt in the second quarter. At the same time, higher oil prices would probably further dent consumer confidence and spending, thereby contributing to the current disinflationary trend due to weaker demand.

Indeed, the big question is whether the higher oil price will once again result in broad-based second-round effects like we saw last year. A lot of drivers of core inflation are at this point still disinflationary, with manufacturing businesses still indicating that input costs are falling despite higher wages and energy prices. And as new orders are weakening, deflation for non-energy industrial goods is realistic towards the end of the year. For services, weaker demand is also contributing to slowing inflation despite higher wage costs, according to the September PMI. Our expectations are that core inflation will slow significantly from the 5.3% August reading towards the end of the year.

Still, if the labour market remains as tight as it is now and the economy bounces back a bit in early 2024, there is a risk that higher energy input costs would also put core inflation further above 2%. A lot depends on the strength of the economy in the months ahead, adding uncertainty for the ECB.

Pressure on the ECB to continue hiking

Prior to the pandemic, most central banks would probably have looked past surging oil prices. Some even considered rising oil prices to eventually be deflationary, undermining purchasing power and industrial competitiveness. However, we are no longer in the pre-pandemic era, but the era of returned inflation. The ECB has emphasised in recent months that doing too little is more costly than doing too much in terms of rates.

For the ECB, the recent staff projections were based on the technical assumption of an average oil price of 82 USD/b in 2024. If oil prices were to average 95 USD/b next year, this would probably push up the ECB’s inflation forecasts to 3.3% for 2024 (from 3.2%) and more importantly to 2.4% in 2025 (from 2.1%). As a result, the return to 2% would be delayed to 2026.

The delayed return to 2% would not be the only reason for the ECB to consider further rate hikes. Even though the ECB would still acknowledge the deflationary nature of a new oil price shock, the risk that this new oil price shock could lead to a de-anchoring of inflation expectations will definitely add to the ECB’s concerns, making not only an additional rate hike more likely, but also that they stay higher for longer.