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Why is the oil price important?

An indicator of global growth, oil is back as the topic of conversation in my household once again – apologies to anyone that finds me, my husband, and our stolen minutes of grown-up evening conversation a bore.

This week the price of oil sank below $45 a barrel for the first time in 2017, likely triggered by an increase in US interest rates and fears that OPEC’s production cut won’t drain the glut of oil supply.

In a bid to tackle the oversupply that’s clouded the market since 2014, OPEC, the powerful consortium of oil producing countries, first penned a deal to cut output by 1.2 million barrels a day (b/d) in late 2016, on the condition Russia chipped in with its own 600,000 b/d reduction. This 1.8 million b/d cut was extended until early 2018 in May.

But many traders aren’t convinced OPEC can deliver its promises, which pushes out an end to the supply glut further. Many argue Saudi Arabia needs to up its game and America needs to help.

How does oil impact inflation

Cheap oil is generally good for consumers; each one penny decline in the oil price adds around $1 billion to the US economy¹.

As the price of fuel falls, we’re left with more cash in our pockets. Fuel is so integral to our industries that cheaper oil lowers manufacturing costs, which feeds into the prices we pay at the till. As prices get cheaper, inflation eases back.

With prices set to soften, long-term inflation expectations have now fallen below 2% in the US and Europe over the last few months, and have softened in the UK, although they are still way ahead of the Bank’s 2% target.

Inflation has accelerated in the UK on the back of weaker sterling since the UK decided to leave the EU last summer. If price growth eases back, at least we should feel some respite in our weekly shop.  

However, oil has been increasingly volatile since March, intensified by OPEC’s decision to extend its oil production cut to early 2018. This could suggest that global growth might not be as strong as we might hope.

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Central Bank conundrum

I’ve mentioned before the tough task global central banks now face in trying to normalise monetary policy. The US Federal Reserve is well on its way, having increased interest rates for the third time this year. Up 25 basis points to a range of 1-1.25%, this move reflects confidence in the US market after a strengthening employment levels.

In Europe, rates remain unchanged, as they do in the UK. The Bank of England’s Monetary Policy Committee voted 5-3 in favour of keeping rates at an all-time low of 0.25% in June, despite inflation reaching a four-year high of 2.9%. It doesn’t help that wage growth is failing to keep up with inflation as well.

In the UK, an increase in rates could help support the exchange rate and reduce imported inflation. But, with the Bank of England so cautious up to now, the normalisation of monetary policy isn’t likely to  be rushed from here.

We’re used to cheap borrowing after eight years of it in the UK. A sudden increase in interest rates will be an additional pain and could weigh on employment.

For that reason, most people don’t expect that the the UK will raise rates this year, even if the Fed is keen to maintain its momentum. The Bank of England won’t have its head in the sand, however, it’s probably outlining the best route to normalisation.

It’s best we don’t either. When we’re feeling the pinch it can be hard to make plans for the future, but it’s better than being caught off guard later down the line.

Careful planning should help protect you from any bumps further down the line. If you can siphon off a bit more each month to either put in a savings account of invest in diversified portfolio – whether managed by yourself or digital wealth manager – you won’t get caught without an umbrella on a rainy day.

1 The Wall Street Journal, Are low oil prices good for the economy

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