Normally, the way that Fed rate hikes are supposed to work is that interest rates go higher, causing commodity prices to sell off, and that helps make inflationary pressures go away.
So why is the opposite happening right now?
Let's rewind. We can actually separate this story into a tale of two halves. In Act One, the Fed's rate hikes did have exactly the textbook effect. Soaring oil and gasoline prices in June 2022 pushed the Fed to upsize its rate hikes to 75 basis points at a time. That finally broke the back of the price rally that had pushed pump prices to a record $5.01 national average, and sent consumer sentiment to a record low.
And for the rest of last year, as the Fed kept aggressively hiking, oil prices remained tame. By this March, WTI crude was trading all the way down in the $60s, versus the nearly $130 per barrel peak we saw a year earlier. Problem solved.
...or was it?
In Act Two now, prices are suddenly on the upswing again. Crude went from the upper $60s barely more than six weeks ago, to hitting $85 a barrel earlier this week. The rally has been so sharp and swift that in some part of the country, prices at the pump have jumped thirty or forty cents in just the past week. As we know, this is a huge risk to consumer sentiment and spending, and could put upward pressure back on headline CPI, which has finally just returned to the 3% range year-on-year.
So why is it happening? In some ways, the rebound was overdue. Every oil analyst you talk to says the global supply and demand balance is razor tight. It's not like we have a glut of oil in the world. In fact, we have a shortage.
Just this morning, the IEA (International Energy Agency) said global oil demand hit a record 103 million barrels for the first time, in June, and appears to be hitting a new high this month. "Chinese demand was...stronger than expected, reaching fresh highs despite persistent concerns over the health of the economy," the agency noted. Supply, meanwhile, has "plunged," to just 100.9 million barrels in July, amid Saudi production cuts, the IEA said.
Because of that deficit, people have had no choice but to draw down their oil inventories to fill the gap. Inventories worldwide are about 115 million barrels below their five-year average right now--if not more, since that figure was as of June, and we appear to have drawn further on stockpiles in July and August, according to IEA.
So where does the Fed come in? (a) The Saudi production cuts happened in response to falling oil prices after their hikes last year. And (b), the destocking of inventories and lack of rebuilding them now is also partly a financial market effect, because it's now gotten too expensive to store barrels of oil, thanks to the higher cost of capital.
Amrita Sen of Energy Aspects talked about this on Squawk Box on Monday. U.S. oil inventories fell by almost 8 million barrels in July, she noted, "even though the market was in contango," meaning futures prices are higher than current ones. "Even a shallow contango in the past would have been an incentive to store oil, [but] it wasn't enough because of the higher cost of capital," she explained.
Instead, people have been destocking, or selling off, their crude supplies. "That was a big reason why we didn't see prices run up in the first six month of this year, but ultimately destocking is finite, and we've run through most of the [excess supplies] now," she warned. We are running down the excess "very quickly," she said, adding that she expects that to be gone by the end of this year, "which does expose us to higher prices for next year."
The same has also been happening in gasoline and diesel product inventories, which could exacerbate the effect. It's why experts from Sen to Rapidan's Bob McNally are warning that any kind of disruption in the coming months--like a Gulf Coast hurricane--could quickly result in a major price spike at the pump.
It's ironic that in both the energy and housing markets, the Fed now faces supply-driven inflationary pressures that stem from its own inflation-fighting rate hikes. But these are of a different nature than the overheating-economy, demand-driven price spikes we saw in late 2020 and 2021. These are more likely to slow the consumer and the economy, but still, I hardly expect the Fed to react dovishly to higher prices. The economy will have to slow much more sharply first.
See you at 1 p.m!
Kelly
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