I was reading a two part article the other morning in Bloomberg Business Week debating whether deflation or inflation is around the corner in the industrialised world… while the economic analysis on both sides was interesting, neither side of the arguments presented seemed to consider how sustainability factors might impact the inflationary outlook…
 
It seems to me that sustainability constraints pose a significant and uncertain supply side factor with the potential to materially impact the overall demand and supply price equilibrium.  The sustainability implications of supply constraints should not be underestimated … in his book, Carbon Shift, Thomas Homer-Dixon argued that the mid-2008 spike in the oil price helped drive the downturn in the US economy.
 
As oil prices escalated, producer input prices escalated, ultimately to the tipping point where producer and consumer demand was essentially choked off … economic slowdown inevitably followed.  Oil also has a disproportional impact on prices because of its embedded position in almost everything consumers buy.  In research by the University of Liverpool’s Oil Dependency Unit it was shown that, when feed inputs costs are also considered, approximately 70 percent of the cost of milk is driven by the oil price. 
 
Today oil prices linger around $110 per barrel while global economic output remains sluggish.  Any significant increase in economic activity will invariably drive up the demand for oil.  Given limited spare capacity in the system – the US Energy Intelligence Administration currently estimates OPEC has around 2.2m barrels per day available (around 2.5% of overall supply) – most likely the oil price will rise.
 
From an inflationary perspective, the key question remains – would a rising oil price drive inflation or could it simply push up input costs to the point of tipping the global economy back into recession?