OPEC just made the Fed's job harder

OPEC+ surprised oil markets on Sunday, 2 April, by announcing a production cut of 1.16 million barrels per day. Brent crude jumped more than 6 per cent to open above $85 a barrel, the biggest one-day gain for energy traders in a year. The timing was deliberate. It came just as the Federal Reserve and Europe's central banks were trying to judge how much the regional banking crisis would drag down inflation. By flexing their pricing power, Riyadh and Moscow have upset the comfortable assumption that cheaper energy would bring inflation down painlessly.

The cartel's aim is plain enough to anyone watching the futures market. It wants a firm floor near $80 a barrel, and it wants to punish speculators who used the banking panic to short crude futures.

From $140 to $70 and back

The cut caps a year of wild swings. Brent came close to $140 a barrel in March 2022, shortly after Russia invaded Ukraine, and America responded with the largest ever release from its Strategic Petroleum Reserve. Prices then drifted lower as recession fears grew and China's lockdowns held back demand. In October OPEC+ cut its production target by 2 million barrels a day, over loud American objections. During the banking scare last month Brent fell to around $70, its lowest in more than a year, and the group evidently decided that was too low.

The new cuts are voluntary and come from a handful of members, led by Saudi Arabia with 500,000 barrels a day, and they run from May until the end of the year. Russia said it would extend its own reduction of 500,000 barrels a day, announced in February, over the same period. The structure matters because it shows the Saudis are willing to give up market share to defend price, which traders had doubted.

Energy costs bite again

The bill lands on central bankers in rich countries. Over the past six months, sliding prices for wholesale petrol and heating oil did most of the work of bringing inflation down in America and Europe, pulling headline CPI lower and giving household incomes a temporary lift.

A lasting rebound toward $90 or $100 a barrel would shut that channel altogether. Having cushioned the inflation figures for half a year, energy would go back to pushing headline inflation up through the summer.

The pass-through is quick. Crude prices reach petrol pumps within a few weeks, and petrol shows up in the consumer price index the following month. Diesel and jet fuel take a little longer, feeding into freight costs, airfares and the prices of goods that are trucked across the country. The effect on core inflation, which excludes food and energy, is slower and smaller, but it is not zero, and it arrives while services inflation is already sticky.

Expectations are the real risk

Central banks worry less about the first-round effect of dearer oil than about what it does to expectations. Petrol is the price households see most often, printed on signs along every road, and surveys of consumers' inflation expectations tend to rise and fall with it. When American petrol prices topped $5 a gallon last June, short-term inflation expectations jumped, and the Fed responded with its first 75-basis-point increase since 1994. A renewed climb in pump prices would test whether expectations have become better anchored since then.

Europe is more exposed still. Euro area inflation was 6.9 per cent in March on the flash estimate, but core inflation hit a record 5.7 per cent, which means the fall in headline inflation relied almost entirely on energy. Take that support away and the European Central Bank faces a core problem with no headline relief.

No room to look through it

That leaves central banks in an awkward bind. They usually "look through" jumps in commodity prices, treating them as temporary supply shocks that squeeze consumers' spending power. With headline inflation above target for two years and inflation expectations still shaky, the Fed cannot afford to be patient this time.

History cuts both ways. In the 1970s the Fed treated successive oil shocks as temporary and let inflation become entrenched, which forced far harsher tightening under Paul Volcker at the end of the decade. The opposite mistake has also been made. The ECB raised rates in July 2008 as oil hit a record, weeks before the financial crisis, and did so again twice in 2011 citing energy prices, only to reverse both moves within months as the economy weakened.

Winners, losers and the counter-case

The gains go to producers and their currencies. Gulf exporters and Russia collect more revenue per barrel, and currencies such as the Canadian dollar and Norwegian krone tend to firm with oil. The losers are importers, especially India, Japan and much of Europe, as well as airlines, haulage firms and households whose budgets are already stretched. For emerging markets that import fuel and borrow in dollars, dearer oil and a firm Fed are a painful combination.

The strongest argument against a lasting shock is demand. If the banking stress tips America into recession, oil consumption will fall and the cut may merely keep prices from sliding further. The cut itself may also reflect weak expected demand, since producers rarely cut into a strong market. China's reopening is the swing factor, and a slower recovery there would limit how far prices can rise.

Supply from outside the cartel is a weaker check than it used to be. American shale producers once answered every rise in price with a burst of drilling, but since the pandemic their shareholders have demanded dividends and buybacks instead of growth. Output in the Permian basin is still rising, just slowly, and a new well takes months to bring on. Any relief from that quarter will come too late to shape inflation this summer.

The signals to watch are the next few weeks of Brent futures, American petrol prices, the March consumer price index due next week and the Fed's decision in early May. OPEC+ ministers are due to meet again in early June. By propping up energy prices, OPEC+ has made it likely that headline inflation stays high into the summer. That will probably keep the Fed from cutting rates even as the banking system shows cracks.