Will bearish sentiment in global energy prices, as well as divergent monetary policy stances in Europe on one side, and the US and the UK on the other, lead once again to a deferral of the beginning of monetary policy normalization?
Both the Bank of England (BoE) and the US Federal Reserve (Fed) have been slowly but surely preparing the markets and households for the normalization of their respective monetary policies. At least that is what the rhetoric on both sides of the Atlantic suggests. Both central banks so far appear like they could lift their respective policies off the ground as early as this year.
However, a similar sentiment was in the air at roughly the same time last year, when markets expected the first rate hike to come as early as before the end of 2014, or early 2015. But a sharp decline in Oil prices last year and the subsequent deceleration in CPI inflation, persuaded even the most staunch hawks to drop their calls for policy tightening.
In Britain, as much as three quarters of the CPI downward deviation off its 2% official target have come from external low inflationary pressures, either in form of falling energy prices, or cheaper imports from Europe due to a stronger sterling against the euro.
Policymakers are again raising those concerns.
Crude has been falling notably recently on over-supply and subdued demand. Even the Fed changed its sentiment on the most recent oil price moves after it dropped in its July FOMC statement the part saying "energy prices appear to have stabilized", mentioned in its June statement.
The BoE was even more explicit about external 'lowflationary' forces, when it said in the July MPC minutes that if the fall in global energy prices persist, "this would be likely to increase the expected near term deviation of inflation from the target." Those downward pressures may indeed persist, though, even with a stronger dollar, with some economists suggesting the price of crude could fall even further below its lows seen at the end of 2014, and beginning of 2015.
The strength of both the US dollar and sterling have also played their part in this weak inflation conundrum. In its July MPC minutes, the BoE policymakers said "the recent appreciation of sterling would be expected to have a direct effect on inflation, bearing down on the CPI relative to the outlook described in the Committee’s May forecast, although the speed and degree of pass - through from movements in sterling was uncertain.” We could therefore expect some slight downward revision to the medium-term outlook for CPI included in the upcoming forecasts, due on August 6 within the BoE's quarterly Inflation Report.
The above suggest either a later lift-off, or very slow and gradual normalization to follow after the first hike. This reflects BoE Governor Mark Carney's recent words, saying on July 16 that "the actual path almost certainly will not be mechanical, linear or pre-determined."
Oversupply pressure to hold oil prices lower
Crude extraction in oil-producing countries seems to be rising faster than global demand, so far limiting any stronger gains on the market. Even the short-term Middle East turbulences, such as Saudi Arabia-Yemen military skirmishes, could not spur a longer correction.
The year 2014 saw a massive pick-up in global production, driven by the United States shale-oil revolution to help their labor market. Such a crucial push on already full supply at that time spurred the first wave of oil sell-off. The Organization of Petroleum Exporting Countries (OPEC) defended its members' output and decided not to lower it, as well as did Russia, and other minor crude-rich countries, which in turn strengthened the bearish rally even more.
The latest news about the nuclear deal with Iran saw another selling wave as the world's fourth largest oil producer is preparing to use its oil to boost the country's revenues after long years of economic squeeze under the sanctions.
On the other hand, expectations of rising demand seem to be justifiable, but demand does not tend to recover that smoothly and requires a longer time to accelerate, while the supply side can be more flexible and change briskly.
The European Union is still struggling with its liquidity-lacking members, which have been struggling under harsh austerity programs. Austerity is definitely not the type of policy that could spur consumers demand, or boost firms.
Nevertheless, there is potential for demand to recover and overcome some major problems.
Even the expected EUR/USD exchange rate is not EU consumer-friendly. The US is on the way to tighten monetary policy, so we can expect the companies to prepare for more expensive borrowing activity. China's central bank has already taken some steps against the liquidity squeeze. The question is if this helps demand from a longer-term perspective.
Even under the pressure of US dollar, which is expected to strengthen further as policy tightens, we still see oil prices falling, or at least staying subdued for most of this year, and the trend is expected to persist into 2016, with only limited gains estimated.
West Texas Intermediate (WTI) could be dragged even to below the $40 level by the end of this year, while Brent is expected to fall to as much as $45 a barrel.
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