Is the new rout in oil getting worrying?

Earlier this morning, the New York Mercantile Exchange was quoting delivery for light sweet crude in July at $43.30. That’s a far cry from the $55 average that analysts had expected for 2017 as recently as last month. And all indications are that this price deflation is not transitory, but lasting.

The selloff in oil brings year-to-date losses to some 23% despite OPEC’s extended production cut agreement. The market seems to be indicating that OPEC has lost control of the oil market because of increased production elsewhere. To wit, rig counts in the US have climbed for 22 weeks on the trot. And many look at these rig counts as a proxy for future production.

Worries. The immediate concern is that this rout in oil prices will be negative for capital expenditure and presage another round of bloodletting in the oil industry. However, the drop in price, while severe, is nowhere near as severe as the drop from over $100 a barrel that preceded the last wave of oil investment cuts. As a result, we should expect the economic impact to be more muted, while the drop in prices will be positive for consumers.

What people are missing is that this weakness in oil prices is not a passing phase. The forces at work are persistent due to the incremental supply in US shale oil. And this will continue to put downward pressure on headline inflation numbers.

Bottom line: We should start looking at the decline in oil prices as a proxy for the Fed’s inability to continue its rate hike train. The more weakness we get in oil prices, the more headline – and core – inflation numbers and inflation expectations will fall. And if inflation numbers fall from here, the Fed will no longer be able to reasonably say it expects to meet its inflation mandate. More focus at the Fed will turn from interest rate hikes to balance sheet reduction.

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