With OPEC+ oil producers struggling to reach their production targets, and the continuing threat of disruption from Russia, the oil supply side remains challenged. (UBS)

Recession talk notwithstanding, the decline in commodity prices is being seen as the turning point in inflation that the markets have been waiting for, allowing the Fed to ease the pace of hikes. While falling commodity prices will certainly help the Fed as it tries to deliver a soft landing, investors should temper their expectations on what this means for Fed policy in the near term.

Oil price slide likely to reverse

For one, commodity prices remain very volatile in an environment where the macro outlook is increasingly uncertain but commodity-specific structural forces in most cases still favor elevated prices.

Oil, for instance, suffered its biggest one-day drop on Tuesday, with the West Texas intermediate crude, the US oil benchmark, tumbling 8% to less than USD 100 a barrel driven by concerns about a global recession and renewed worries that China may once again resort to lockdowns in Shanghai to combat another COVID-19 outbreak. By the end of the week it had rebounded USD 105 a barrel but was trading weaker again on Monday.

We maintain our view that the oil market remains very tight and expect the decline in prices to be short-lived. Oil demand has also held up despite higher prices. Strong demand for travel in the Northern Hemisphere, along with a rebound in China’s growth in the second half of the year should sustain demand for oil. Meanwhile, the supply side remains challenged, with OPEC+ oil producers struggling to reach their production targets, low spare capacities to meet future supply interruptions and the continuing threat of disruption of oil supply from Russia.

We see the price of Brent crude rising to USD 130 a barrel by September and trading around USD 125 through to the middle of 2023.

Outside of oil, the slide in base metal prices has been swift and across the board, which, again, is more reflective of the change in the macro narrative rather than commodity-specific factors. We have recently lowered our forecasts for base metals to reflect higher recession risks, but our top- down view of the world economy is still positive given our constructive outlook on China, and we believe that structural factors, both supply and demand related, support higher prices for base metals over a 6-12 month horizon.

Labor market, not commodities, remains key

Second, even if commodity prices stay off their highs, it is unlikely to alter the Fed’s path in the near term. We expect the June inflation numbers to still be uncomfortably high for the Fed, and the impact of lower oil prices in recent weeks will only be evident in later prints.

The headline numbers feed inflation expectations and the Fed will be watching it closely. If headline inflation continues to fall aided by lower food and energy prices, it can certainly help the Fed proceed at a more gradual pace later in the year. But the Fed is also looking for conclusive evidence that inflation is moderating and is unlikely to put too much stock in fluctuating commodity prices amid volatile markets. Instead, it will focus on more reliable signs that the demand side of the economy is slowing, such as a cooling in

housing activity and most importantly, loosening labor market conditions While falling commodity prices can help lower inflation, so long as labor markets remain extraordinarily tight, the Fed will not be able to bring inflation down to the 2% levels consistent with its mandate.

The labor report for June which was released on Friday, showed that the job market remains extremely tight. The economy added a much better-than- expected 372,000 jobs, the unemployment rate remains unchanged at 3.6%, and the labor force participation rate ticked down to 62.2%, back to January’s level. The decline in the participation rate suggests that workers returning to the labor force cannot be relied upon to alleviate labor shortages. Job openings in May stood at 11.25 million, far in excess of the number of unemployed workers at less than 6 million.

Fed on track to hike 75 bps in July

We expect the Fed will likely hike rates by another 75 basis points in July bringing the federal funds rate to the 2.25%-2.50% range, historically considered the neutral rate. The strength in the labor market provides the Fed both the impetus to raise rates aggressively and also the confidence that it can do so without causing too much damage to the economy.

While the risks of a recession have certainly increased, we do not think it is inevitable and there remains a narrow path to a soft landing. As we head into the fall, we should have more evidence that the collective action of central banks around the world is slowing the global economy, allowing the Fed to proceed at a more measured pace.

Main contributor: Solita Marcelli, GWM Chief Investment Officer Americas

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Original report - What do falling commodity prices mean for inflation? 11 July, 2022.