The Correlation Between Energy Prices and Core Inflation

Central bankers often focus on core inflation readings, excluding food and energy prices. However, a recent surge in crude-oil prices has brought attention to the correlation between energy prices and the core reading of the consumer price index. DataTrek Research notes that this correlation has returned to levels seen in the 1970s and 1980s, with a reading of 0.62 since 2020 compared to an average of 0.68 in previous decades, well above the long-run average of 0.31.

The Importance of Core Inflation Measures

Core measures of inflation aim to remove volatile items such as food and energy. While some commentators may roll their eyes at this exclusion, as these items constitute a significant portion of consumer expenditure, the rationale behind it is that these items are less responsive to monetary policy. Therefore, policymakers place greater emphasis on the core reading to get a better understanding of what they can influence. The core personal consumption expenditures (PCE) index, often referred to as the Federal Reserve's preferred inflation indicator, is a prime example.

Acknowledging the Impact of Rising Energy and Food Prices

Despite the focus on core inflation, rising energy and food prices cannot be ignored. Energy, as an input, can have an influence on overall prices. DataTrek co-founder Nicholas Colas emphasizes the significance of energy prices on core inflation, stating, "Recent data shows that energy prices hold more sway on core inflation than at any time since the 1970s/1980s, so rising oil prices are a legitimate concern for both the Federal Reserve and capital markets. Food inflation falls into the same category."

By considering the correlation between energy prices and core inflation, policymakers and investors can better navigate potential impacts on the economy.

Oil Prices Surge and Fuel Costs Rise

Oil prices have experienced a significant rally throughout the summer months. The momentum was further intensified when Saudi Arabia recently announced its decision to extend a production cut of 1 million barrels per day until the end of the year. Additionally, Russia has pledged to continue reducing its supply.

On Wednesday, West Texas Intermediate crude (CL00), the U.S. benchmark, achieved its ninth consecutive day of gains. Similarly, Brent crude (BRN00), the global benchmark, rose for a seventh consecutive day. Both grades reached their highest levels of 2023 before experiencing a slight pullback in the Thursday session.

This surge in crude oil prices now poses the risk of driving up fuel prices, including gasoline and diesel.

According to investors and analysts, the recent increase in oil prices is partly to blame for the uptick in Treasury yields. As market participants consider the likelihood of higher interest rates or the possibility of additional monetary tightening by the Federal Reserve, yields have risen. Consequently, the U.S. dollar has also strengthened, reaching a six-month high according to the ICE U.S. Dollar Index (DXY), which measures the currency against a basket of six major rivals.

The rise in Treasury yields has impacted U.S. stocks, particularly the technology and growth sectors that are more sensitive to interest rates. The Nasdaq Composite (COMP) is set to record a 2.3% decline for this shortened week, while the S&P 500 (SPX) has pulled back by 1.6% and the Dow Jones Industrial Average (DJIA) has lost 1.1%.

With oil prices on the rise once again, concerns arise regarding its impact on inflation. Will the increase in crude oil prices impede recent disinflationary trends? This is a question pondered by Colas and other experts.