The recent drop in oil prices is allaying fears of inflation. But inflation won’t moderate quickly; it will go down only if oil and other commodity prices stay down.

Inflation is measured year over year, and economists expect oil prices for the rest of this year and early 2009 to be above year-earlier levels. Prices are not expected to slip below year-earlier levels until the second quarter of 2009.

But as long as oil prices don’t go up again, the percentage contribution of gasoline and fuel costs to inflation will decline. At US$115 a barrel, oil prices are 53% more than they were in the third quarter of 2007, when they were US$75 a barrel, but only 26% more than 2007 Q4’s US$91 and just 17% more than 2008 Q1’s US$98.

So, there should be some moderation of inflation earlier than 2009 Q2, particularly in the U.S., where the recent appreciation of the U.S. dollar will lower the cost of imports not priced in US$. (Oil and other resources are priced in US$.) Ben Bernanke, chairman of the U.S. Federal Reserve Board, recently pointed to the higher US$ in support of his view that inflation should ease in 2009.

The year-over-year increase in the U.S. consumer price index was 5.6% in July. Six of seven financial services economists surveyed by Investment Executive are forecasting U.S. inflation of 4%-4.7% this year and 2.4%-3.1% in 2009.

Canada is a different story, however. Inflation has not gone up to the same extent in Canada as in the U.S., thanks to the high Canadian dollar. The loonie has reduced the price of oil, metals and grains — which all contribute to inflationary pressures — in C$ terms.

Economists’ forecasts for Canadian inflation in 2008 range from 2.3% to 2.8%, within the Bank of Canada’s target band of 1%-3%.

It is a similar story for 2009. The C$ is a petrodollar and follows oil prices, falling in response to lower oil prices. That means that the price of oil will not come down as much in C$ terms, so inflation will not drop as much here as in the U.S. But inflation is still expected to be less than it is south of the border; the six economists’ forecasts for Canadian inflation in 2009 range from 1.5%-2.5%.

In both Canada and the U.S., sluggish economic growth is also expected to dampen inflation by reducing wage demands.

But the forecasts all depend on oil prices remaining low — and Jeff Rubin, chief economist with Toronto-based CIBC World Markets Inc. , doesn’t think that is likely.

Rubin is assuming average oil prices of US$150 a barrel in 2009 and has talked about the possibility of US$200 oil. As a result, he expects inflation in 2009 to be 4.5% in the U.S. and 3.9% in Canada. He thinks wages will have to go up to compensate workers for their higher gasoline and fuel costs, which sets the stage for ongoing higher inflation.

That’s the big danger in a period of high inflation. If companies raise prices, then find that their input costs have come down, they can reduce prices to increase sales. But if wages have increased, it’s next to impossible to reduce those.

Rubin believes that cost-of-living allowances — which were prevalent in wage contracts in the 1980s — will make a comeback. His thesis is that American workers are feeling more secure in their jobs; big increases in the cost of shipping goods across the Pacific Ocean has lowered the risk of losing their jobs to competition in China. Combine that with paycheques being eaten up at the gas pumps, and demand for higher wages is likely.

On the other hand, counters Adrienne Warren, senior economist with Toronto-based Bank of Nova Scotia, there is much less unionization now than two decades ago. Besides, she says, given sluggish growth, layoffs and rising unemployment, North American workers don’t have much bargaining power. Even if oil prices average US$135-US$140 next year, as she assumes, she doesn’t expect big wage increases.

Warren does expect lower growth than most other financial service economists, however, which is consistent with her position on wage demands. Real gross domestic product in 2008 will rise by only 1.5% in the U.S. and 1.1% in Canada, she forecasts; in 2009, she expects only 1% GDP growth in the U.S. and 1.6% in Canada.

@page_break@Paul Ferley, assistant chief economist with Royal Bank of Canada in Toronto, is more optimistic. He is forecasting U.S. GDP growth of 1.9% in both 2008 and 2009, and GDP growth in Canada of 1.4% this year and 2.5% in 2009. He is basing his assumptions on an average oil price of US$90 a barrel in 2009. So, his stronger growth forecast shouldn’t lead to wage demands.

But if it turns out Warren is right on oil prices and Ferley is right on GDP growth, there could be some pressure on wages.

Like Ferley, Clement Gignac, chief economist and strategist with Montreal-based National Bank Financial Ltd., expects oil prices to fall below US$100 in 2009, predicting average prices of US$75-US$80.

Don Drummond, chief economist with Toronto-based TD Bank Financial Group, is forecasting US$100-a-barrel oil in 2009, while Doug Porter, assistant chief economist with BMO Nesbitt Burns Inc. in Toronto, and Carlos Leitao, chief economist with Laurentian Bank Securities in Montreal, are both assuming oil prices around US$115.

But these economists are not complacent. Leitao thinks there is still a risk of rising inflation and, thus, higher wage demands in the interval before inflation drops significantly.

And if commodity prices start climbing again, Porter says, with oil reaching US$150 a barrel, there is a real risk of stagflation, or rising inflation in a period weak GDP growth.

Economists are also concerned about price increases in other goods and services. Ferley calls the seasonally adjusted 1.2% jump in the U.S. producer price index in June and July “a bit disturbing.” He was surprised by the 1.4% increase in passenger car prices, given weak demand in the sector.

Leitao says the increases in the price of services is “a little outside the comfort zone,” noting that core services — those unrelated to food and energy — are more than 3% above year-earlier levels in the U.S. This suggests it’s too early to dismiss inflationary concerns.

Oil is not the only commodity that has produced inflationary pressure in the past year. Food products are also a concern. Wheat prices, for example, rose very sharply, hitting a high of US$787 per metric tonne in February, vs an average of US$293 in August 2007. It has fallen since but, as of Aug. 15, was still well above year-earlier levels, at $408.

Food is less of an threat than oil — at least, in the industrialized world, in which packaging and marketing account for a substantial portion of retail prices. Porter, however, calls food “an ongoing concern” in the medium term. It’s less dramatic than oil, he says, but its effects could be more long-lasting.

It’s a different story in the emerging world. There, consumers buy raw foods, and food is a much bigger proportion of most people’s budgets. As a result, central banks in those regions may have a harder time containing inflation. There is also the risk of social unrest if food prices keep climbing.

Metal prices have been more subdued, with recent declines bringing copper, nickel and zinc prices below year-earlier levels in mid-August. Metal demand is tied more to economic growth than to energy. So, although prices are high by historical standards, they don’t present an inflation threat, given sluggish GDP growth in the industrialized world and slower growth in emerging countries.

But a few companies control most of the production of key metals, Leitao says. If one of them cuts production, it is almost guaranteed to push up the price of that metal. Switzerland-based Xstrata PLC has done just that for nickel, temporary suspending its nickel production and processing at a mine in the Dominican Republic. IE