GAS PRICE UP & DOWN

The Fed Has A Problem: Inflation May Hit 3.5% By December Due To Gas Price “Base Effect”

Submitted by Tyler Durden on 05/26/2016 14:57 -0400

One of the officially stated reasons why the Fed delayed hiking rates so far, is because inflation in late 2015 and early 2016 has been lower than the Fed’s bogey (as long as one does not look at core inflation, or such critical price levels as asking rents and health insurance). And, based at least on the CPI’s basket weighing of headline input prices, the Fed may have been right: the main reason for this is that tumbling energy prices have resulted in a sharp drop in gasoline prices at the pump, one of the primary drivers of Headline CPI.

What is left unsaid is that keeping rates low has been a blessing in disguise for the Fed: following the early 2016 market rout, which was the functional tightening equivalent of three rate hikes, Yellen was happy that inflation was low enough to let her get away without a rate hike so far this year.

However, as we approach the anniversary of last year’s oil – and gasoline – price lows and the base-effect goes away, the sharp pick up in gas prices is set to have an even sharper upward impact on Consumer Price Inflation. It will also wreak havoc on the Fed’s strategy of playing possum and not hiking as long as inflation remained “stubbornly low” because suddenly inflation will be the highest it has been in years.

In short: the Fed suddenly has a problem. Here’s why.

As BofA writes in a note today, the recovery in oil prices this year should lift headline CPI inflation, “confirming the transitory nature of the energy drag.” What is startling, however, is that assuming BofA’s gas price forecast is right, the bank calculates that its baseline forecast is for CPI to rise to 2.4% by year-end 2016 from the current 1.1% reading. This forecast uses futures prices for wholesale gasoline (RBOB) to estimate future energy prices.

Note that 2.4% CPI inflation in December is BofA’s base case, based on an all too realistic gas price of $1.77/gallon retail ($1.41 wholesale). According to BofA’s “bull case” in which gasoline returns to its historical price of $2.76/gallon ($2.06 wholesale) would more than triple headline inflation from its current 1.1% level to a whopping 3.5%: this would be a shock to the Fed, to inflation expectations, and to the market. It would also force the Fed to hike rates far faster than the market currently expects.

Here is the math:

Futures wholesale prices are set to inch up from $1.64/gallon to $1.65/gallon in June before ending the year at $1.41/gallon, above the December 2015 level of $1.27/gallon. We sensitize our inflation forecast by defining “bull” and “bear” cases for gasoline prices in addition to our baseline. In particular, we use the highest and lowest observed RBOB price over the last twelve months. This means a bull case of $2.06/gallon and bear case of $1.07/gallon wholesale, by year-end, with the shock gradually building over our forecast horizon. $1.41/gallon wholesale would be $2.11/gallon for retail gasoline, assuming a steady wholesale-retail spread of $0.70 (which covers distribution/marketing and taxes). Our “bull” case would be $2.76/gallon retail and the “bear” case would be $1.77/gallon retail.

The impact of the base-effect is so pronounced, that as BofA notes, an extreme bearish scenario is needed for inflation to stall. A far less extreme scenario is needed for inflation to jump dramatically. To wit:

Our analysis shows that there is a clear uptrend in CPI ahead, under most reasonable scenarios (Chart 1). CPI would accelerate to 3.5% yoy under our bull case, and rise to 1.6% under our bear case. Supportive base effects are a key driver. It is only under an extreme bear case (year-end wholesale gasoline price of $0.88/gallon, or retail at $1.58/gallon), that we would see CPI inflation flatten out at 1.1%, all else equal.