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Is oil about to reignite another fire under inflation?

It’s a question on many minds after two of the biggest suppliers of the world’s most important commodity raised the temperature last week.

Saudi Arabia shocked markets on Sept. 5 by announcing that a voluntary cut of 1 million barrels a day initially pledged for just July would be extended until the end of the year. Its OPEC+ ally Russia followed suit, extending its cut of 300,000 bpd.

Brent crude shot up above US$90 a barrel for the first time since November 2022 on the news. This morning the benchmark was trading at US$90.50 and U.S. West Texas Intermediate crude at US$87.08.

The squeeze will draw down oil inventories just as consumption is growing. Rystad Energy predicts that global demand will exceed supply by about 2.7 million bpd in the final quarter of this year.

It also threatens an inflationary spike that could disrupt the plans of central banks, such as the Bank of Canada, to wind down their cycle of interest-rate hikes.

“Suffice it to say, rising oil prices are perhaps the last thing the global economy needs at this point, when inflation expectations were on the cusp of finally receding,” said BMO Capital Markets chief economist Douglas Porter in a note Friday.

The reality that inflation had not yet been tamed weighed on financial markets, he said, pushing bond yields higher, especially in Canada where a hawkish hold by the Bank of Canada last week was followed by a stronger-than-expected August jobs report.

“While the chances of another rate hike by the BoC are still seen as a bit less than 50-50, no one is fully closing the door on the possibility,” said Porter.

“It will be a nervous couple of months, as Canada’s headline inflation rate is also about to take a serious trip north on higher energy prices.”

Gasoline alone, now up 8 per cent year over year, will be enough to take headline inflation to about 4 per cent in the next few months, he said.

“The next rate decision in late October will thus be staring down a marked back-up in CPI, and the Bank will need to see some signs that core is still ebbing to keep them sidelined,” said Porter.

That could happen. CIBC chief economist Avery Shenfeld said the surge in oil could end up being deflationary for other items in the consumer price index.

“Gasoline won’t be a friendly component of the CPI the way it was earlier this year, but disinflation in other goods and services can take over the job if labour income gains and higher interest rates put enough of a squeeze on what consumers can afford to pay overall,” he wrote Friday.

BMO economists believe the Bank of Canada has raised enough, Porter said, considering signs that the economy is stalling and the job market loosening, despite August’s gains.

But there is one more “wrinkle.” If the United States Federal Reserve hikes again it will put pressure on the Canadian dollar, which at 73.3 US cents is already down almost 5 per cent year over year, further aggravating inflation.

“Thus, while we and the market cautiously believe the Bank is done raising rates, the persistent strength in oil prices is an unwelcome intruder in that cozy consensus,” said Porter.

“The bottom line: Not to oversimplify, much, but: higher oil prices = higher interest rates.”

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LEADING INDICATOR

Economic surprise seem par for the course these days — and the August job numbers out Friday were no exception. The 40,000 gain was double expectations and with wage inflation hotter than forecast the reading is bound to raise concerns at the Bank of Canada.

But while employment is rising so is unemployment, said RBC assistant chief economist Nathan Janzen. Population growth in August (a record 103,000) outpaced the increase in employment, keeping the jobless rate steady at 5.5 per cent. 

The Bank held its rate last week based on signs that balance in the labour market was improving and “the unemployment rate holding steady after three months of increases is still likely consistent with that view for now,” he said.  

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