Why a strategist who previously thought inflation was contained now sees potential for aggressive Fed rate hikes

By Nora Redmond

Refined oil products are pricing in extreme scarcity

West Texas Intermediate and Brent crude prices have remained above the $100-a-barrel level.

A once-optimistic strategist is beginning to feel a real "sense of foreboding" about inflation because of the growing divergence between oil and refined energy prices.

Albert Edwards, global strategist at Société Générale, had previously been advocating for the Federal Reserve to hold interest rates at the current level of 3.5% to 3.75%, despite markets pricing in a 93% chance of rates being hiked by a quarter of a percentage point, according to FedWatch.

The central bank will announce its decision at 2 p.m. Eastern time on Wednesday, followed by Fed Chair Kevin Warsh's press conference 30 minutes later.

Live coverage: Fed meeting today: Rate hike all but certain as investors await Warsh and company's decision

Edwards cited the core consumer-price index, which has stayed around the 2% mark for about three years now, and the offset of rising commodity prices by slowing wage inflation and productivity growth as reasons the Fed should consider maintaining the current rates.

Now, however, he is "beginning to become worried" and feels a "sense of foreboding" about the near-term inflation outlook.

Referring to a note written by Société Générale colleague Mike Haigh, head of commodities, Edwards wrote that, if investors are focused on West Texas Intermediate (CL00) and Brent crude (BRN00) remaining above the $100 a barrel mark as signs of market tightness, the true story is worse than it seems.

"Gasoline, diesel and jet fuel markets continue to price an environment of extreme scarcity," Haigh wrote in a note published last week. "Product prices and especially cracks have risen to unprecedented levels relative to crude, creating one of the largest disconnects between crude and refined-product pricing ever observed."

Gas prices at the pump are in fact far beyond what would usually be associated with the current levels of oil prices, more closely aligning with prices at about $150 a barrel, while for diesel and heating oil users the current retail price is more what one would anticipate at $190 a barrel, according to the French bank.

The main reasons for the divergence is damage to oil infrastructure in the Middle East and Russia and inventory levels that are unusually low for this period in the year, with stocks of diesel down to nearly 30-year lows.

"But what I find so staggeringly worrying is unless there is a quick resolution to the Iran/US war (unlikely?), the price of refined products could jump still higher because the crack spread is so profitable," Edwards said, adding that sectors of the economy such as retail, wholesale and residential builders have likely used the crisis to engage in "greedflation," or profit-driven inflation, a term popularized by the German economist Isabella Weber.

The crack spread refers to the price difference between crude oil per barrel and the petroleum products, such as diesel and gas, extracted from it.

"If greedflation persists, any further near-term surge in refined petroleum product crack spreads will likely also be more than passed on to the consumer and subdued labor costs will continue to be pocketed as ever expanding profit margins," Edwards wrote. "If greedflation continues to take root, the Fed might have to end up hiking rates much more aggressively than I had thought previously."

-Nora Redmond

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