ORLANDO, Fla., Nov 2 (Reuters) - The direction of travel for global interest rates seems clear: they are about to rise - perhaps significantly, if some market pricing is to be believed - as nervous central banks try to put the inflation genie back in the bottle.
There's a strong case to be made, however, that if oil prices fall or even just plateau at current levels, policymakers' hawkish turn may prove to be mistimed at best, or a catastrophic, growth-choking policy error at worst.
While energy no longer has the same weight in inflation and household spending it did in years gone by, the correlation with consumer prices and market-based inflation expectations is still tight.
It's worth bearing this in mind as central banks in developed economies start to unwind post-pandemic stimulus. The tide has already turned in emerging markets, and this week the Federal Reserve will likely lay out its taper timetable while the Bank of England could even raise rates.
All else being equal, fading year-on-year energy and commodity price rises will exert a downward drag on inflation, certainly headline measures. The question then is to what extent, and whether services and core inflation cool as well.
Economists at Capital Economics calculate that if oil prices remain flat at current levels around $85 a barrel, energy's contribution to inflation in developed economies would fall "considerably" next year, by 1.6 percentage points by year-end.
In terms of headline rates, unchanged oil would help lower inflation across developed markets to 2.2% at the end of next year from 4.7% this year, they reckon. That is broadly in line with most central banks' inflation goals of around 2%.
If more balanced supply and demand dynamics push Brent down to $60/bbl next year, as the Capital Economics team expects, developed market inflation could fall to 1.7%.
Economists at Credit Suisse agree that base effects will kick in next year as well. "In 2022 inflation is very likely to fall and be below 2.5% in the U.S. in core terms by the end of the year," they wrote in a note last week.
DRUM BEAT
Normally, a $10 change in oil roughly translates into a 0.5 percentage-point move in headline U.S. inflation. Oil has risen nearly $70 from its pandemic-low in April last year, an indication of how much it is feeding into current inflation.
Brent crude troughed at $16/bbl in April last year, surging more than 300% over the next 12 months to $66/bbl. Its 60% rise so far this year will continue to factor into inflation readings next year, but the impact is fading.
Several measures of headline and core consumer inflation are moving above central bank targets to levels not seen for up to 30 years: 4.4% in Canada, 5.4% in the United States, 5.5% in Spain.
The drum beat for rate hikes to nip this in the bud is getting louder, perhaps too loud.
Traders are now discounting 125 basis points of tightening by the end of 2022 from the Bank of England, starting this week; two Fed hikes next year; 125 bps of tightening in Canada; and even 25 bps from the European Central Bank.
Inflation breakeven and swap rates are far from perfect, but they are important gauges of market-based inflation forecasts. They are also very closely correlated to oil prices.
BREAKEVEN INVERSION
Some central banks, namely the ECB and Reserve Bank of Australia, have tried to push back against the aggressive tightening priced into the front end of rates curves. But markets are ignoring them.
The tail now appears to be wagging the dog. Paradoxically, however, markets are also warning central banks that if they deliver on the aggressive rate hikes currently being discounted, they risk committing a grave policy error.
This is reflected in the significant extent to which the back end of yield curves have flattened recently, even inverted. The 20s/30s UK curve is its most inverted since 2009, and the U.S. 20s/30s curve inverted last week for the first time ever.
U.S. inflation breakeven curves also show that investors think inflation in the longer term will be lower than the near term. Inversion of these curves is rare and fleeting, but is now at unprecedented levels.
Market pricing and positioning does seem to point towards a world of higher inflation and interest rates than at any time since the Great Financial Crisis. And oil prices could surge further, as analysts at Bank of America are predicting with their Brent call of $120 by next June.
Policymakers are in a tough position.
"There is a decent case that inflation falls next year, but the problem is the market won't believe it until it sees it," says Steve Englander at Standard Chartered.
(By Jamie McGeever; Editing by Andrea Ricci)
