Diesel price surge adds new inflation pressure beyond oil shock, Scotiabank says

A surge in diesel prices, driven by challenges in the Middle East and Russia, is adding a distinct new layer of inflation pressure beyond a typical oil price shock, economists at Scotiabank warn.

"This is no longer just an oil shock," said Olivier Gervais, director of modelling and forecasting at Scotiabank Economics.

Historically, refined products like diesel move with crude oil, but usually by less. This episode, however, looks quite different, Gervais said in a report this week.

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The price of refined products has been pushed higher than oil this year because of challenges in transporting the products through the Middle East and because the Ukraine conflict has shut down some of Russia's refining capacity.

"These two events combined led to a crunch in the supply of diesel in the global market and sent prices higher," said Gervais.

To determine the impact, Scotiabank isolated the diesel price movements that could not be explained by crude oil and tracked their effect through consumer and producer prices.

"We find clear evidence that the inflationary effects extend beyond energy in both Canada and the United States," said Gervais.

The economists calculate that a temporary increase of about 15 per cent in the diesel spread, close to what is being seen now, would raise consumer price index inflation in Canada by 0.6 percentage points and by 0.8 points in the U.S.

This pass-through is not limited to headline inflation but shows up in underlying measures as well.

"When diesel prices rise independently of crude oil, the impact does not stop at the pump; it leads to broader price pressures later on," said Gervais.

The pass-through is gradual and persistent, the report said. Because diesel is critical to trucking, agriculture, construction and manufacturing, higher fuel costs spread through freight, production and distribution networks before reaching consumer prices.

Transportation prices are the first to rise, followed by food, shelter and other categories a year to 18 months later as higher costs work their way through the supply chain.

A separate study by Oxford Economics found evidence that U.S. trucking companies are already passing part of the fuel shock onto customers.

Neither are major crude producers with domestic refineries protected, as oil and refined products trade in global markets that set the prices.

"Even large producers such as the U.S. and Canada remain exposed to higher global crude and diesel prices despite having greater domestic supply security than major importers," Oxford Economics said.

Scotiabank warns that if the energy shock persists it will become far more dangerous.

"Product-price shocks are usually short-lived, so that risk should not be overstated," said Gervais.

"But the longer the shock endures, the greater the likelihood that firms pass on higher costs more forcefully, inflation expectations become more sensitive and monetary policy is forced to respond more aggressively."

The Bank of Canada and the Federal Reserve would be willing to look through a temporary price shock, but if it spreads to broader inflation expectations, they would be forced to hike interest rates higher.

"With upside risks beginning to accumulate, this new shock adds fuel to the fire," said Gervais.

With files from Financial Post