WTI Crude Oil Price Plunge

From its 2018 peak on October 3 to November 13, the price of a barrel of West Texas Intermediate crude oil fell by 27%. In the later stage of its decline, it closed at a lower price for 12 consecutive days, something it’s not done in at least 35 years. This of course has significant first order implications for the energy industry and for the economy at large. Perhaps less intuitive, however, is the effect that a falling oil price may have on Fed policy. As the price of oil has fallen, so too have inflation expectations. Over last six weeks, the 5-year breakeven inflation rate has fallen from 2.07% to 1.88%. Regressing the breakeven rate against the price of oil from the beginning of 2009 through November 13 generates this relationship:

5yr BE = 0.932+0.01*WTI, with an R square of nearly 40%.

This has had the effect of pushing one measure of the real fed funds rate (fed funds rate minus 5-year breakeven rate) up to its highest level since January 2009. While the market’s expectation of a December rate hike remains largely unchanged, its outlook on subsequent hikes in 2019 has become less clear. If oil continues to fall, and inflation expectations with it, the Fed’s efforts to normalize policy may involve an earlier-than-expected intermission.