OPEC's surprise production cut complicates the Fed's fight against inflation

Washington, DC CNN

Economists warn that a surprise announcement of a production cut this week by Saudi Arabia and other OPEC+ producers could complicate the Federal Reserve's efforts to cool the US economy. It may also worsen inflation.

Last year, energy prices soared across the globe when Russia invaded Ukraine. This fueled global inflation at a time when the major economies of the world were just beginning to recover from the pandemic.

According to the Consumer Price Index, since then, the drop in energy costs has helped to cool US inflation. It has dropped from a peak of 9.1%, which was a record high for 40 years, in June, to just 6%, in February.

According to the Bureau of Labor Statistics, energy prices, which account for around 7.5% of overall index, rose 5% from February last year. This is a far cry from the 41.3% increase in June of last year.

With oil prices once again surging, headline inflation may remain high or even increase. The average price of gasoline in the United States is already higher. According to AAA, the national per gallon average was $3.55 last Thursday, up from $3.40 one month earlier.

Even core inflation can be affected

Fed officials use a variety of economic metrics to guide their decisions, but one that is of particular importance is core inflation. This excludes volatile energy and food prices. Oil prices are a major factor in core inflation, but they can also push it up if they stay high for a long time.

Sarah House, senior economics at Wells Fargo told CNN that the Fed views OPEC's decisions as primarily geopolitical. However, they can have an impact on production and transportation. Therefore, higher oil prices could affect the core component of the economy, which is what the Fed tends to focus more on when setting policy.

Plastic resin is one example of a crude oil derivative that's used to make everyday items like bottles, clothes, and wires. Jet fuel prices have a direct impact on airfares.

The role of consumer spending is crucial

Higher energy prices soften demand by impacting consumer sentiment and spending. Both were surprising robust at the start of the year, but recently have started to cool.

The University of Michigan tracked consumer sentiment and it fell to the lowest level ever recorded in June last year when gas prices hit $5 per gallon. Since then, it has improved as gasoline prices have declined.

Carl Tannenbaum is the chief economist of Northern Trust Corporation. He said that energy prices have a powerful influence on people's expectations about inflation. However, at this time, they don't hold a strong grip over consumer psychology.

He said that if the price of gasoline per gallon goes over $4, it's another story.

John Leer is the chief economist of data analytics company Morning Consult. He said that weaker consumer spending can have mixed effects on inflation. It can lower inflation for businesses that provide services, but it can also increase chances of the United States entering a recession.

Leer explained that if consumers allocate a larger share of their budget to energy costs, it will limit their ability spend money in other areas. So, on a realistic basis, the demand would contract.

In an interview with Bloomberg, James Bullard, President of the Federal Reserve Bank of St. Louis said that the volatile nature of oil prices makes it difficult to keep track of them. He acknowledged that higher oil prices would eventually have an impact.