Why Higher Inflation from Oil Prices Won’t Necessarily Result in Higher Long Rates

It’s no secret that fluctuations in oil prices can lead to dramatic swings in headline price inflation, as chart 1 below shows. After all, not only does oil fuel the vast majority of transportation needs, it’s also a critical raw material used in consumer products far and wide, and much of the price swings in oil are passed on to consumers. With oil moving higher compared to year-ago prices, we should naturally expect a transitory boost to headline CPI as a result. In fact, if WTI crude prices stay flat through June, the year-over-year price increase would be 45%. But because oil market fundamentals are so strong currently, we think it a high likelihood that oil prices move higher from current levels. This would mean the year-over-year increase oil prices could be substantially higher than 45% by June, and that the headline CPI could be closer to 3% than the current 2.2%.

Wouldn’t a big increase in inflation driven by oil prices result in much higher long-term interest rates? Not necessarily.

It’s important to remember that long-term nominal interest rates are a function of three variables: growth expectations, inflation expectations, and term premium. Treasury Inflation Protected Securities (TIPS) rates, are the sum of growth expectations and the term premium (the added yield investors require to hold longer dated bonds). Because nominal treasury rates and TIPS rates are observable in the marketplace, we can infer what inflation expectations are by subtracting the TIPS rate from the nominal bond rate. In other words, if nominal 10-year bond yields are 2.5% and TIPS yields .5%, then market implied inflation expectations would be 2%.