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Monday July 24, 2006 - 15:25:35 GMT
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Economics Weekly: At what level will oil prices dent global economic growth?

Will oil prices eventually hit economic growth?
Oil prices hit a record high in nominal terms recently as fighting in Lebanon intensified, yet the economic effect of this rise in oil prices remains minimal. Recent figures show that economic growth in the UK was 0.8% in the second quarter of 2006, 2.6% up on the year before and the fastest pace since the second quarter of 2004. Economic growth in China hit an annual rate of 11.3% in the second quarter, the fastest pace since 1992, after 10.6% in the first. Growth in the US was 5.6% in the first quarter, the fastest pace since 2003. In fact, consensus estimates of global economic growth for this year have been increased by 0.3% from those made in January. We pose two questions in this week’s briefing: the first is how can this be? The second is: at what level will oil prices hit economic growth?

Many reasons account for the current response of global growth to oil prices…
The most important reason why the rise in oil prices has not had the same impact as that of 1973/4 and 1979/81, is that it is not a supply side shock but has been due to a rise in demand. Geopolitical tensions, instability in some parts of the world and fighting about getting a rightful share of the revenues from oil in others have all contributed to some disruption to supply. Nevertheless, figures from the International Energy Agency shows that oil supply has actually gone up overall in the last year or so. Importantly, this rise in demand has been gradual, thus giving users and suppliers some time to adjust. Moreover, low global inflation due to low cost producers principally in Asia and intensive global competition make it easier to absorb price rises without needing a response from the monetary authorities in the form of higher interest rates. Third, a view that central banks would respond aggressively to any excessive (above target) rise in inflation must also have helped to keep down price expectations, in particular keeping wage inflation down. Fourth, the increase in the demand for oil is coming from those emerging markets that are seeing the strongest growth in demand. Since they also have low costs that too helps to prevent global inflation from rising too sharply. Fifth, in real terms, adjusted for inflation, oil prices are still some 30% or so below their peak in 1980. Finally, at the same time as the foregoing, the previous high real price has driven countries to become more efficient in their use of oil, mitigating the impact of the current rise.

…but oil prices of $120 would lead to global recession
But the question still is, given the risk from the current level of geopolitical tension and the risk of another hurricane season like last year impacting oil markets today; at what level would oil prices damage economic growth? We estimate that this would occur if the average oil price hit $120 a barrel and stayed there for at least a year (we assume $90 in Q4 2006 then $120 from Q1 2007). We have conducted such a scenario using a large scale global economic model. The outcome is shown in table 1. Global economic growth would fall to just over 2%, i.e. recession levels, and down by one-third from the base case. Such is the overwhelming impact of the speed and severity of the rise that inflation increases as well, by 1.9%, and so interest rates respond, up 1.5% compared to base. The country most affected out of the major economies is the UK, where growth falls more sharply and then recovers more rapidly. We put this down to the high level of UK household debt, which makes it more susceptible to increases or cuts in interest rates. Chart a shows that Chinese growth falls to about 6%, some 4% below its base case, as global growth is badly hit by the rise in oil prices. But cuts in interest rates as a result of weaker growth means that the world economy begins to work off the effects of the oil price rise by 2009, when growth is only 0.3% below the base case. (This assumes that oil price are still at $120 a barrel, which is a tough assumption as the fall in growth should also have resulted in a fall in the oil price.)

UK responds more to shifts in interest rates
Looking more carefully at the UK, we see that inflation jumps up more rapidly than in the rest of the world, as it has less spare capacity and operating closer to full employment than in some other major developed economies. But as UK interest rates are cut in response to weaker growth, its economy bounces back more quickly than the global average in 2009, then prompting a rise in interest rates. Why is this? The following charts (c, d, e & f) for the UK show that consumer spending falls into negative territory in 2007, but then bounces back strongly in 2008 as interest rates are cut. A flexible UK labour market means that wages adjust downward, see chart c, helping the subsequent recovery. But this is not enough to prevent investment spending from also falling sharply, though it does not turn negative, possibly due to lower wage costs. However, cuts in consumer spending and investment spending lead unemployment to rise quite sharply, even with lower wage inflation. The latter would have exacerbated the fall in consumer spending and probably also have some very negative effects for the housing market and mortgage lending. Individual and corporate default rates would likely rise sharply in this scenario as well. The final UK chart shows that with government spending also already high, weaker growth leads to a substantial rise in government indebtedness, perhaps threatening the Chancellor’s rules for fiscal policy. The UK economy bounces back by 2009, however, as the flexibility of the labour market helps to mitigate the effects of the oil induced recession.

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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