Forget rate hikes these economists say to tame inflation, we need cheap oil

Rising interest rates will increase borrowing costs and slow the economy. But they won't address one of the biggest drivers of inflation: fossil fuel costs.

The chair of the U.S. Federal Reserve, Jerome Powell,took the dramatic step of increasing borrowing costs by 0.75 per cent, a move Canada is expected to follow.He said the move will slow demand and help get the jobs market balance out.

"But there are many things we can't affect," Powell told reporters this week in Washington.

"Those would be commodity price issues we're having around the world due to the war in Ukraine."

Inflation numbers in Canada released last month laid the facts out for all to see. Overall, the consumer price index was up by 6.8 per cent from the year before;1.8 percentage points of this was due to energy overall, while1.3 percentage points of it was due to gasoline alone.

So, about a quarter of April's growth in the price index was a direct result of energy prices. But even that doesn't capture the whole story.

"Oil permeates every aspect of our lives. It's not just at the gas pump," said Laura Lau, chief investment officer with Brompton Funds.

Lau says the indirect impact of energy prices is felt in just about everything we buy.

"It feeds through to all the goods that are shipped," Lausaid. "For instance if you go to the grocery store, someone had to deliver all that stuff to the grocery store."

So, it's difficult to get a specific read on just how much higher energy costs are driving overall inflation numbers. But just about everyone agrees, it's hard to see how inflation as a whole begins to fall without a drop in oil prices while the economy is still so dependent on fossil fuels.

It's not just about the war

BMO's chief economist, Douglas Porter, says the first step isn't a drop, it's finding a way to slow the steady increase we've seen in global oil prices.

"What we really need are those oil and gas prices to stop rising so relentlessly first and foremost. That's what we need," said Porter.

But that's easier said than done.

The war in Ukraine is often cited as the key driver of increasing energy costs, and there's no doubt it's playing a role. But oil prices were already shooting up before the war began.

Remember, oil prices fell off a cliff just as COVID-19 crashed into the economy in 2020. Prices fell briefly into negative territory. The market was already over-supplied just as the world shut down to get the virus under control.

During the pandemic, oil companies everywhere slowed production dramatically as cars, trucks and airplanes all sat idle for months at a time.

As the global economy emerged from the crisis, demand slowly increased. Some production came back on-line, but it was clear by the end of last year that the world was headed for another imbalance in the oil industry. This time, instead of too much oil sloshing around world markets, there was a real risk there would be too little.

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Even as demand increased, oil companies were wary of spending money to boost supply. For the first time in a long time, they were seeing decent profits.The previous decade was a rough one for investors, not just duringthe COVID catastrophe.

That meant the price of oil rose steadily through the end of 2021 and the beginning of 2022.

"Oil prices were actually $90 [US] per barrel before Russia invaded Ukraine," said BMO's Porter.

So, you know, [the oil industry] had a pretty serious inflation issue even before the Russian invasion of Ukraine, that just kicked it into hyperspace."

The question is what happens now.

The challenge of adding supply

Economistsoften say the cure for high prices is high prices. Sure, oil companies are making record profits with the cost per barrel hovering around $110 US. But they know they could produce more oil and make even more money and that supply could bring prices down.

Lau says that's not as easy as flipping a switch. She says workers were laid off during the pandemic and found other jobs in less volatile industries.

Governments around the world are trying to transition away from the oil industry toward more renewable sources, she notes.

But Lau says that transition won't come in time to get the world out of this crisis.

"Renewable energy's not quite there yet," saidLau. "Will it be one day? I hope so. I really hope, but we're not quite there yet."

She says the oil sector has been repeatedly and globally "admonished" by governments keen to get climate change issues under control.

"These companies have been told by the president, by the prime minister, we don't need you. You're adinosaur industry." (Even the International Energy Agency has called for an immediate end to oil, gas and coal expansion to reach net-zero emissions by 2050.)

Meanwhile, she saysshareholders who took a bath on energy investments don't want growth. They want to enjoy some high profits and encourage the companies to pay down some debt.

"I think there will be production growth," saidLau. "But it's not going to 20 to 30 per cent as it was in the past. Because you don't get rewarded for that."

Meanwhile, Russia remains locked in a war in Ukraine and China is emerging from yet another lockdown. Both of those factors will push prices even higher.

BMO's Porter doesn't sound optimistic.

"To get inflation down quickly. It would really help if oil prices broke," he said. "But unfortunately, that doesn't look like it's, it's about to happen."

Which brings us back to central banks raising interest rates. It's easy to push rates higher now, when lending prices are still at historic lows. The question is what do they do down the road when rates are still on the rise, economies are slowing but the price of oil hasn't budged?

Central bankers and politicians hope that rate hikes are the cure for what's ailing Canada's economy.But it might actually need a shot in the arm cheap oil that governments and central banks simply can't deliver.