While the spike in oil prices has prompted concerns about high prices leading to a recession, economists say oil prices are less important than monetary policy.
In a new report, economists at CIBC World Markets said the impact of high oil prices on inflation and economic growth are top of mind these days, particularly as the latest spike in oil came on the heels of already-high prices
“If sustained, the current elevated level of oil prices might inflict more damage to the economy relative to historical shocks,” it noted.
The price of Brent crude settled lower on Tuesday, trading below US$100 after topping US$120 last week.
While previous price rises have prompted increased capital spending in the domestic energy industry that boosted the Canadian economy, CIBC said, that may not be the case now.
“With the transition to a low carbon economy only expected to accelerate, capital expenditures in the oil patch are unlikely to dance to the tune of oil prices as closely as in the past, depriving Canada’s economy of its usual positive offset during times of elevated energy prices,” the report said.
However, the news isn’t all bad. Past oil shocks provided a spark to inflation that may not be as strong these days either.
“During the oil shocks of the 1970s and early 1980s, energy prices were a catalyst for an entire wage-price spiral that sent shockwaves through core inflation. But since then, the relationship between energy price spikes and core inflation has weakened notably,” the report said.
Indeed, CIBC noted that inflation is less sensitive to oil prices these days than in the past, given its diminishing significance within the consumer price index overall and its weaker impact on core inflation.
In part, this is the result of increased efficiency.
“Over the past decade, the final energy demand necessary to create a unit of GDP in Canada has dropped by more than 10%,” the report noted.
Additionally, economists stressed that while oil shocks may have preceded major recessions in the 1970s and 1980s, it was the central banks’ response that ultimately drove the economic outcome.
“The oil shocks of 1973-74 and 1979-80 are often held responsible for the economy’s plunge into recession,” noted National Bank Financial (NBF) economists in a report. “What is less often mentioned is the important role played by monetary policy.”
In fact, the U.S. Federal Reserve had shifted to restrictive monetary policy before those energy price booms, NBF said.
“Instead of coming to terms with the supply shocks, the U.S. central bank opted, in both cases, to pursue the hunt for inflation even though the economy had already entered a recession,” it said.
This time around however, the spike in oil prices occurred before the Fed has started raising rates.
As a result, NBF said it doesn’t expect the Fed to hike rates as aggressively as markets currently expect.
CIBC echoed the conviction that monetary policy is a bigger factor in determining the economy’s course. The fact that higher oil prices are now a weaker driver of inflation should allow the Fed and the Bank of Canada to focus on more durable sources of price pressure, such as wages and rent costs, the report said.
“Even if energy prices remain elevated, the offsetting forces of less responsive energy sector capital spending, alongside reduced energy intensity in the Canadian economy and a smaller pass through of rising energy prices to consumer price inflation, will work to soften the inflationary sting,” it said. “Therefore, we do not expect the current energy shock to notably alter the Bank of Canada’s rate trajectory.”