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Monday August 15, 2005 - 10:14:04 GMT
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Will higher oil prices really have no impact on the global economy?

Economics Weekly: Economic Research and Analysis: Will higher oil prices really have no impact on the global economy?

Oil prices hit another peak

In the last few weeks, the price of crude oil in nominal terms has hit record high after record high. Yet this has not led to panic in the financial markets about the consequences for global growth and inflation. Why is this?

Lesson from history
It is well known that an increase in oil prices pushes up general inflation because it leads
to higher prices but it also leads to weaker growth because it reduces the amount those paying the rise in oil prices then have to spend on other items. But it is also likely that the net effect will depend on where the economy of those paying the increase in oil prices is in its business cycle. If growth is weak, and companies cannot pass on the increase in oil prices, then the general impact on price inflation will be limited. If the rise in oil prices is from a supply shock, however, that restricts its availability for every level of demand, then that could lead to both slower gdp growth and higher economywide inflation.

This was crudely the situation in the oil price shocks of the 1970s and 1980s: they were supply driven and so demand had to be cut back severely as a result so weakening growth yet not after adding to inflation. Add in lax fiscal and monetary policy in the 1970s and early 1980s and the potential effects were severe, as shown in chart A for the UK. The world economy experienced recession in each instance of oil price shocks during this period.

Markets believe inflation contained
This time the view taken of global economic conditions by commentators is a lot different. Financial markets seem to believe that if the increase in oil prices comes from a rise in demand then the inflation effect will be also be weak, as growth is fast enough to mean that companies are better able to absorb it in their profit margins, which therefore also means that the inflation effect can be contained. Moreover, if actual price inflation is also low, then firms cannot pass on much of the oil price increase without losing market share and so will have to absorb much of the rise in their costs. Of course, there may still be weaker economic growth if enough companies then cut back on investment but this should not mean recession.

Oil having smaller impact on economy
Monetary policy today is much more likely to react to signs of inflation, as people believe this so price expectations are currently low and expected to remain so. But also oil usage is much less than in the past, per unit of growth. In the UK, this is shown by the fact the share of spending on energy by households out of total expenditure has fallen by around 50%, from about 4% to 2%, see chart B.

There is also another effect keeping the impact of the current rise in oil prices weak; namely, the difference between real prices and nominal. This means that although oil prices have reached a nominal peak, adjusted for inflation, oil prices are still some 40% below the highs seen in the early 1980s, see chart C. This means the impact is therefore correspondingly less. This does not mean that economic growth will not be affected, but that it should not lead to recession. In addition, since inflation remains low, there is no need for monetary policy to be tightened to fight it and so weaken growth.

Oil prices driven more by demand than supply
There is a lot of evidence that the increase in oil prices in is fact demand driven, with demand not just coming from the emerging markets of China, India and Brazil, but also from the developed countries of the US, Japan and those in the EU economic area. At the end of July crude oil stocks in the US were at the highest level since 1999. Crude oil production in OPEC countries is running at 30.4m barrels a day and rising, according to oil experts from the International Energy Authority (IEA). And production in non OPEC countries has also been rising, with more expected to come on stream in 2005 and 2006, though estimates vary. Many calculate that demand and supply in recent months have actually been roughly in line. So why are prices rising?

When will oil prices fall back?
One explanation seems to be that refinery capacity cannot keep pace with demand for the right type of oil being demanded; higher quality so called ‘sweet’ crude. Moreover, there is a lot of speculation around at present, stemming from worries about Iraq, Saudi Arabia and terrorism, which is also acting to keep oil prices high. Markets may have good reason to be relaxed; prices could fall as sharply as they have risen if some of the speculation were to unwind. But a rise to around $70 a barrel first cannot be ruled out.

Economic indicators
UK economic indicators this week follow the Inflation Report last week. We look for consumer inflation, out on Tuesday, to edge above the 2% target for the first time since May 1998, due to oil prices. But the decision to cut interest rates by the MPC at the August meeting, minutes released Wednesday, was likely to have been a unanimous one. After a rise of 1.3% in June, it is very likely that retail sales growth, out Thursday, fell back in July, but only by around ˝% to leave activity some 2% up on the year before. Labour markets have seen a modest loosening in recent months, with unemployment up a little and wage inflation easing back, and more of the same is expected on Wednesday when the latest data are released.

Trevor Williams, Chief Economist
[email protected]
Lloyds TSB Bank,
Financial Markets
Faryners House,
25 Monument,
London EC3R 8BQ
0207 283 - 1000

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