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This transcript has been generated using machine learning technology. While this technology was trained with CIBC terminology, it may contain errors.
Introduction: Welcome to Eyes on the Economy by CIBC Capital Markets, a podcast series dedicated to addressing current issues in a concise format, helping to make sense of the evolving economic complexities so that you can take action.
Pull Quote: Now, of course, the oil shock will persist a little longer than that. It&#8217;s going to take time to ramp up production again. There is some damage that needs to be repaired, but we&#8217;re assuming that transits through the Strait of Hormuz will pick up pace over time and that essentially oil prices will be back to a new normal at some point in the fourth quarter.
Andrew Grantham: Hello, I&#8217;m Andrew Grantham, and welcome to another edition of the Eyes on the Economy podcast. At the moment, every portfolio manager, central banker, and almost every corporate CEO has to think through what scenario is most likely for the length of the Iran conflict and the resulting path for energy prices and inflation. We at CIBC Economics, we&#8217;re in the same boat, and today I&#8217;m joined by our Chief Economist, Avery Shenfeld, to discuss some of the nuances that we&#8217;re looking at and how this could impact the Canadian and US economic outlooks going forward. Now, Avery, let&#8217;s start, I guess, with our base case forecast about the duration of the oil price shock that we&#8217;re currently going through. What do we think is going to be the most likely scenario for this, and when should we expect prices to ease back a little bit?
Avery Shenfeld: So, oddly enough, I guess we find ourselves in complete agreement with Donald Trump in the sense that he says that the conflict will end soon. And that&#8217;s our view as well, and whether soon means a week or two, or a little bit longer than that, it&#8217;s not something that drags on for months. Now, of course, the oil shock will persist a little longer than that. It&#8217;s going to take time to ramp up production again. There is some damage that needs to be repaired, but we&#8217;re assuming that transits through the Strait of Hormuz will pick up pace over time and that essentially oil prices will be back to a new normal at some point in the fourth quarter. Now, the new normal is not likely to be $60 a barrel. There&#8217;s likely to be a remaining risk premium in the energy market, but, say, somewhere between $75 and $80 a barrel in the course of the fourth quarter, that&#8217;s the base for our forecast. Now, why is that the most likely of all the possible scenarios? It really comes down to American politics more than anything else. If you look at what polls suggest the most important issue is for voters when they&#8217;re thinking about which party they support, polls consistently show that affordability, the cost of living, those are the top issues in Americans&#8217; minds.
And while Trump has said that oil through the Strait of Hormuz is not an issue for the U.S. because they have their own oil, the reality is he knows full well that it&#8217;s very much an issue for the U.S., and that Americans pay the world price for oil and therefore something akin to the world price for gasoline as well. And the sharp rise that we&#8217;ve seen in inflation on top of an inflation rate that was already a little bit too sticky to the high side for the Federal Reserve&#8217;s liking means that a long war, simply put, would be a huge political liability for the Republicans in the midterm elections and a big distraction for the administration in getting anything else on its agenda done, not just from here to the midterms, but maybe perhaps after that. So, we think that Trump will ultimately have to settle for something less than the total and complete surrender and victory that he was looking for.
Will negotiate something with the Iranians that he can claim is a win for the US, however fragile that looks, and wind this up relatively quickly. And so that&#8217;s what we&#8217;ve assumed in the rest of our forecasting for the North American economy.
Andrew Grantham: And so this new normal in terms of oil prices, kind of getting back not quite to where we were, but certainly down from where we are today. What would this path for oil prices from here to the end of the year mean for inflation and monetary policy, both in the US and Canada?
Avery Shenfeld: Well, it&#8217;s not going to be pretty, and that&#8217;s why you have central banks sort of saying that they&#8217;re standing by to defend their inflation targets if need be, because they&#8217;re cautioning that, and they know that we&#8217;re going to see some inflation numbers that are going to look well above those targets for a while, and they want to reassure markets and hold down expectations for future inflation by saying that they&#8217;re going to defend their targets.
But the reality is that, in the US, we will probably see a CPI somewhere close to 4%, perhaps as early as April or May. So, we&#8217;re not done with that. We&#8217;re going to see Canadian inflation winding itself up to the 3% mark. We&#8217;re going to lose the ground that we painstakingly achieved in Canada, get inflation back to two or even less. But it is temporary. And that&#8217;s the important thing.
And that&#8217;s also the important thing for the US political environment as well, because, you know, Americans still view the cost of living through a different lens than that CPI. They know that cars these cost a lot more than the CPI would indicate because they&#8217;re loaded up with features that prior cars didn&#8217;t have. And they know that mortgage rates, which don&#8217;t factor into the US CPI, are also making home buying more expensive.
So, this extra bit of inflation is going to be politically a challenge for governments on both sides of the border. But the key really is here, and for central banks, is that monetary policy isn&#8217;t based on where inflation is today. But, like Wayne Gretzky, who had to go where the puck was headed rather than where it already was, central banks have to plan monetary policy for inflation is headed over the course of the next year, year and a half.
And if you get oil back to $75 to $80 a barrel, then inflation will be essentially back to target in Canada by the time we get to the end of the year, or, if not, then shortly thereafter. And then, the US, well, it might not get all the way back to target. It&#8217;s going to be close enough that if the economy weakened, the Fed could well be considering rate cuts as it was earlier, rather than the rate hikes that the market has been musing about. So, we don&#8217;t expect to see the Bank of Canada or the Fed tighten monetary policy if they understand or end up seeing, at least, that this was a short-lived spike in inflation. And in the US side, given some of the fragility in the growth numbers we&#8217;re seeing, the likelihood that by 2027, AI will be less of a contributor to growth.
We&#8217;re seeing some deceleration in consumer spending, growth in the US, and housing is weak on both sides of the border. To us, that suggests that the Fed, particularly under a new governor or Fed chair who&#8217;s more dovish, likely to deliver a couple of rate cuts before the end of the year if our scenario for the war plays out. And in Canada&#8217;s case, essentially a no-move central bank. So, waiting and seeing is going to be the watchword for the Bank of Canada really right through the year.
Andrew Grantham: Yes, and we&#8217;ve heard central bankers talk about, you know, they&#8217;ll have to see this inflationary spike broadening into other areas. If it is only a temporary spike, then hopefully that lessens the probability of it broadening beyond what we&#8217;ve already seen in terms of airline fares and maybe what we expect as well in some food inflation going forward. Obviously, though, you know, our base case scenario is just one scenario which could happen in oil prices, and people are getting a little bit more worried about a more prolonged spike in terms of oil prices and what that could mean in terms of the economy, particularly the US economy, where oil prices, whether it be causation or correlation, have often preceded US recession. So, just talking through some of those different scenarios that could play out, if oil prices were to remain elevated, what are the risks, particularly for the US economy, but also for Canada as well? And in what ways do we see the US being more or less vulnerable than what we&#8217;ve seen in terms of historic oil price shocks?
Avery Shenfeld: Well, one thing we do have to remember is that, while oil prices may feel high to us, and they&#8217;re certainly a lot higher than they were before, in current dollars, in other words, adjusted for inflation over the decades, they&#8217;re still well below the past peaks that were associated with recession. So, if you go back to the 1970s oil shock, for example, in today&#8217;s dollars, oil prices reached almost $150 a barrel. So, we could get there if there is damage to the oil fields in the Gulf region and if this conflict really lasts long enough to outlive the strategic petroleum reserves that are being released, but we&#8217;re not there yet. So, we&#8217;re not really in the times of territory, either in the 70s or, in fact, ahead of the global financial crisis where we saw oil prices contribute at least to a recession scenario. But also, in terms of causation, if you remember the story from the recession in 2008, that wasn&#8217;t just about oil prices. It was rather that the elevated oil prices then had the central bank hiking rates, and rate hikes exposed the fragility in the US credit markets related to mortgages and shaky derivative securities. And it was that house of cards in the financial market that was then very vulnerable to higher interest rates that caused the recession. And we tested this economy. I mean, maybe some credit metrics have grown since then, but we certainly put it into the test to the rate hike cycle that followed the recovery from the COVID recession and didn&#8217;t see the same sort of collapse. So, it&#8217;s not all causation here, and oil prices are not as high. Then, if you look at both the US and Canadian economies, there are reasons why we should be a little less sensitive, certainly relative to where we were in the recession that ended the 1970s expansion. For one, both Canada and the US in the 70s were major net importers of oil, and both are now exporters, particularly Canada, but the US is a slight net exporter of oil and petroleum products if you put both together. And the second thing is that we use a lot less oil, or even more broadly, a lot less energy per unit of GDP than we did even 10, 20 years ago. That&#8217;s because of the growth in the service sector relative to goods, less energy intensive.
It has to do with the energy efficiency of modern vehicles and appliances. Now, that does mean that, of course, we buy bigger vehicles because they&#8217;re more energy efficient. And so we don&#8217;t see the full decline in oil consumption that we might have otherwise. But we still, relative to GDP, don&#8217;t consume as much oil or energy. And even if you look at the impact on the CPI, the share of gasoline in the CPI currently in the US, it&#8217;s around 3.5%. It&#8217;s gone up as prices have gone up. But if you go back to 2011, for example, even then, it was about 5.5% weight as a share of the CPI. So, each percentage increase in gasoline prices doesn&#8217;t actually raise the CPI as much and therefore doesn&#8217;t squeeze consumer spending quite as much as it did back then. Now, none of this is saying that a long war that actually did major damage to these oil producing regions&#8217; assets couldn&#8217;t cause a global recession. It certainly could. It just says the bar to see that outcome is a little higher. It will certainly dent economic growth, and we&#8217;re going to see this in some upcoming months where prices are going to be running faster than wages. So, real incomes are going to take a bit of a squeeze, and that will show up in softer consumer spending both in the US and Canada. But again, in a short-bore scenario, we can live with a few months of disappointment.
Andrew Grantham: Yes, we have economies here which are a little bit less sensitive to all prices than they were in the past, but we&#8217;re kind of forecasting or hoping at least that we don&#8217;t test that theory for too long. So, that wraps up another edition of this podcast. Like always, we&#8217;ll be keeping our eyes on the economy and energy markets, and we&#8217;ll report back what we see in future podcasts.
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Oil shocks and the economy: The base case and other scenarios

CIBC Economics

Avery Shenfeld

Managing Director and Chief Economist

CIBC Capital Markets

Andrew Grantham

Senior Economist

CIBC

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