Monetary policies and their impact on the oil market
In early 2022, major central banks stepped up their monetary tightening measures in an effort to reign in increasing levels of inflation and recalibrate their overheating economies amid continued strong global economic growth. These tightening measures, in combination with the COVID-19 situation in China and the geopolitical developments in Eastern Europe, contributed to oil market volatility over the course of the year.
By the end of 1Q22, inflationary pressures forced many major central banks to become even more hawkish, most notably the US Fed, which had a considerable impact on oil markets as well. However, the trend in, and pace of, policies were not uniform in all countries. The Bank of England raised rates by late 4Q21 and the US Federal Reserve (Fed) followed suit with an initial announcement to increase their policy rate beginning in 1Q22 and continued with more hikes until the year’s end. Meanwhile, the European Central Bank (ECB) and the Bank of Japan maintained their accommodative rates for a longer period of time, in an effort to support markets and keep capitalization rates low.
These divergent monetary policies had three major results, namely, they: (1) strengthened the US dollar, (2) raised the average cost of capital and (3) inverted the yield curve for short-to-long- term US bonds. With regard to the first point, as most commodities are priced in US dollars, the appreciation of the US dollar, relative to other currencies, led to an increase in commodity prices, including oil. Additionally, the safe-haven appeal of the US dollar rose relative to other currencies amid the strong and rapid rise in US interest rates.
Additionally, the strengthening of the US dollar, along with the rapid monetary tightening by the US Fed, put upward pressure on non-US government bonds and increased bond market sell-offs outside the US, leading to some fragility in the global economy. Furthermore, the rise in US interest rates increased the cost of capital, hindering capital investment, notably in the oil industry. Moreover, high-interest rates weighed on investors’ risk appetite and contributed to a decline in liquidity, which also affected the oil futures markets. With regard to the third point, the rapid monetary tightening created an inverted yield curve in the US, with the consequence that short-term interest rates are higher than long-term interest rates. This is generally regarded as a warning sign that the US economy is likely to head into a recession in the coming months.
Emerging market economies also saw monetary policy divergences. China maintained its accommodative policy rates to sustain its economy. However, its economy continued to be challenged by the zero COVID-19 policy and the ongoing issues in the property and construction markets, which contributed to a y-o-y decline in oil demand for the country in 2022. Brazil raised interest rates early on, at a time when its economy received support from rising commodity prices. India resisted raising rates earlier in the year, providing a base for relatively strong economic growth in 2022, but then decided to lift rates by 2Q22. While oil demand in the country remained strong, inflation had a limited impact, as India benefited from discounted Russian crude oil imports.
By the end of 3Q22, monetary tightening policies were largely aligned across major central banks, with the exception of China and Japan. However, by year-end, Japan’s central bank also became more hawkish in tightening its yield curve control measures. The extent to which monetary tightening will slow economic growth, particularly in advanced economies, and subsequently drag on oil demand in 2023 remains to be seen. In light of the ongoing challenges, OPEC and non-OPEC countries participating in the Declaration of Cooperation will continue to coordinate their efforts to sustain a balanced and stable oil market in order to support healthy global economic growth.