On the other hand | Is an increase in oil prices inflationary or disinflationary?

The sharp increase in the price of oil in the wake of the Iran conflict has ushered in a plethora of central bank warnings about the inflationary consequences of such an increase.

What worries central banks is that a surge in oil prices might result in inflation expectations becoming unanchored and ultimately self-fulfilling.

The decidedly hawkish tone adopted by developed country central banks is largely aimed at avoiding a repetition of what played out during the 1970s in the wake of the first oil shock that followed the 1973 Yom Kippur War and the second shock in the wake of the Iranian revolution in 1979.

When the history of central banking in the 1970s came to be written, it was thought that central banks were “too accommodating” of oil price shocks.

The narrative seemed to be that central banks in general, and the Fed in particular, were too quick to ease the monetary brakes after the first oil shock, thereby failing to seal the inflation genie securely in the bottle. The result was that when the second oil shock hit, already elevated inflation expectations became unanchored, and the genie got well and truly out of the bottle.

It took the harsh but necessary Volcker medicine of the late 1970s/early 1980s, which saw US overnight rates (fleetingly) approach 20 per cent to get that inflation genie back in the bottle. (The process took a little longer in Australia).

The experience of the late 1970s/early 1980s notwithstanding, an alternative narrative with respect to oil prices tended to take hold under the Fed Chairmanship of Alan Greenspan.

This was that the activity diminishing consequences of an oil price surge were of greater consequence than the price effects. Therefore, the bigger risk was that the economy tipped into recession, and that would ultimately be disinflationary.

So which is it? Are oil prices inflationary or disinflationary?

I suspect that the answer largely depends on what might be happening with structural elements that have a bearing on inflation.

Throughout the developed world, the post-World War 2 period through to the end of the 1970s was marked by a greater confidence in governments being able to seamlessly regulate desired economic outcomes.

There may have been some benefit from such an approach, but there were also substantial economic costs in terms of structural rigidities, reducing the flexibility of economies to respond to shocks (inflation shocks in particular). The result was a growing inflation proclivity (or “stickiness”) in developed economies.

Perhaps that was why inflation expectations were so hard to contain in the 1970s.

The 1980s through to the early 2000s were marked by a more deregulatory approach. Certainly, that was evident in the financial sector, but also in labour and goods markets. This increased economic flexibility in goods and labour markets and was a factor in the “Great Disinflation” of that period.

Other structural currents served to put a lid on inflation. The collapse of communism in the former Eastern Bloc and the opening of China and India elicited a wave of skilled migration to developed countries. Governments were focused on lowering tariffs and fostering domestic competition. Baby-boomer participation in the workforce was increasing (particularly female participation), which led to a relatively abundant labour supply that arguably kept wage growth lower.

It was because of a litany of such structural suppressants to inflation that oil prices through the period from the mid-1980s to the early 2000s tended to have more disinflationary consequences, at least in the medium-term.

However, as noted by Professor Charles Goodhart, former Bank of England Monetary Policy Committee member and a distinguished Emeritus Professor at the London School of Economics, those structural suppressants (particularly those associated with labour supply shocks) are probably in reverse.

The globalisation of labour supply (after the fall of the Berlin Wall and the “export” of labour from large emerging market economies such as China and India) is abating.

The globalisation of goods markets is in retreat as governments resort to protectionist measures (most notably with the Trump trade measures in the US); domestic regulation of goods and labour markets is increasing in scope, leading to loss of flexibility in markets and attendant upward price pressures or “sticky” inflation; and baby boomer workforce participation is declining.

A potentially important mitigant to the foregoing inflation scenario is put forward by Fed Chair designate, Kevin Warsh. He conjectures that disinflation in the US will follow from tremendous (largely AI-motivated) investment. In Warsh’s view, that investment has wrought a productivity dividend that (other things equal) has raised the US economy’s “speed limit”. In other words, the US economy can grow at a faster rate before igniting inflationary pressures.

That is a credible, if still highly debatable position. For all the talk of US productivity exceptionalism (which certainly exists), the Fed’s favoured core private consumption expenditures (PCE) measure is “sticky” at just above 3.0 per cent, unchanged from where it was a year ago and still well north of the Fed’s target 2 per cent.

Bearing that in mind, and the abatement of structural inflation suppressants, it might be that today’s world is more redolent of the 1970s, and a surge in oil prices may have a longer-lasting inflation impact.

That will mean that central banks have to be more attuned to the importance of anchoring inflation expectations than they may have been during the three decades from the mid-1980s.

And that means a period of higher interest rates.

RBA: time to “pause and reflect”?

Last week’s relatively benign February monthly CPI report probably eases the pressure on the RBA to execute a “hat-trick” of rate rises when it next meets in May.

If we take the Governor at her word (as I think we should), if the closeness of the vote at the last meeting was “more about timing than direction,” then there may be some breathing space in May that affords the RBA to take on board a little more data before reconvening in mid-June to contemplate the utility of further tightening.

But it is a close call.

That is also the view reflected in the local bond market. In the wake of last week’s report, markets were pricing roughly a 60/40 chance of a May tightening.

If pressed, I would see the probability of a May tightening at something lower than 50 per cent (bearing in mind the Governor’s timing/direction comments). In other words, there may be some scope for “pause and reflection”. That might change in the event of an adverse March inflation report and/or any uptick in wage pressures in the wake of the ACTU claim for a 5 per cent increase in the minimum wage.

In any case, I strongly suspect that further tightening is in store as the year progresses because getting on top of the inflation remains the more important focus.

In my view, the Australian economy has developed an inflation proclivity that is greater than that which might exist in other developed countries.

There are elements to that proclivity that are homegrown, such as an almost egregious inattention of governments (both State and Federal and Labor and Coalition) to policies that might ease structural constraints on inflation. In most instances this involves “unintended consequences” of regulatory creep in labour and goods markets.

There are other elements that are more global in nature. In large measure these involve the reversal of several structural forces suppressing inflation that were present in the three or so decades leading into the pandemic, as outlined above.

I am not suggesting that the current circumstance is one that is anywhere near quantitatively on a par with the stagflation of the 1970s. But there are elements that are redolent of that time, albeit on a substantially reduced scale – “stagflation-lite” if you will.

As to the argument that a surge in oil prices is ultimately disinflationary, I have my doubts (refer above: Are oil prices inflationary or disinflationary?)

That may have been true through the 1990s and into the early 2000s when those structural inflation suppressants were active.

It is less true in 2026.

What the foregoing means is that central banks need to be more attuned to inflation risks now more so than at any other time since the 1980s.

That has particular relevance in Australia given its inflation proclivity.

So even with a “pause and reflect” in May, the RBA might still need to reload in June.

RBA: operating in a new communication paradigm

There was some suggestion at the RBA Governor’s press conference that followed the decision to further increase the policy rate that the RBA had “miscommunicated” its position in the lead-up to the meeting.

The contention was that both the Governor and her Deputy had strongly intimated that a tightening of policy was extremely likely at the March meeting.

The fact that the decision was a finely balanced one, as exemplified by the 5-4 vote in favour of an increase in the policy rate, was taken in some quarters as RBA “miscommunication”.

The Governor (rightly in my view) pushed back strongly on that notion. She suggested that the new arrangements that accompanied the An RBA Fit for the Future review initiated by Treasurer Chalmers meant that every meeting was a “live” one, and this was what she and her deputy had wished to communicate.

In other words, those new arrangements have changed the operating communications paradigm for the RBA’s monetary policy decisions.

The new arrangements sought to give alternative viewpoints to any RBA institutional one. Those alternatives now have a voice and the power to challenge and debate the RBA staff’s view.

That is arguably not a bad thing.

But in this context, it is inevitable that when a diversity of voices is heard, then discerning a “consensus” view is made more difficult.

This perhaps reflects what markets (should?) have known all along: that monetary policy and its appropriate stance are something that reasonable people can disagree on. The appropriate stance of monetary policy is not a black and white decision.

When non-RBA staff MPB members feel inclined to communicate their views (as I understood the new arrangements to envisage), that will become clearer. RBA communication might therefore become more about the various factors that feed into an eventual decision.

The downside might be that real debate at the Monetary Policy Board (MPB) level of the RBA means that any particular decision becomes harder to telegraph.

The upside is a more rigorous debate where the operating institution is subject to a greater degree of interrogation of its recommendation.

As the Governor hinted in her press conference, that sort of debate and diversity heralds a more disciplined approach to decision-making.

Markets and the media may have to get used to the new communications paradigm.

In that endeavour, they might be assisted by more communication from non-RBA staff members of the RBA MPB.

Stephen Miller is an Investment Strategist with GSFM. The views expressed are his own and do not consider the circumstances of any investor.