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Economics Weekly

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Oil price fall to boost global growth in 2009?

Tue, Aug 19 2008, 06:59 GMT
by Trevor Williams

Lloyds TSB Financial Markets

Oil prices have fallen back quite sharply from a peak of close to $150 a barrel just a month ago to around $112 presently. But in real terms (adjusted for price inflation) oil prices have risen in the last five years to exceed the peak levels of the oil-induced economic crisis of the late 1970s, see chart a. Oil prices and oil price shifts have the ability to have a big impact on economic growth and inflation, through the effect on incomes and from the monetary policy response. But higher oil prices elicit a strong response in another way as well - by inducing energy efficiency and technical change that reduce the amount of oil used in output and so ultimately reduce the real price of oil. That is what is implied in chart a, which shows that after peaking in the 1970s, real oil prices then fell steadily in the 1980s and remained at very low levels for the next 20 years, only starting to rise in a consistent manner since 2004.

Short term challenges from recent oil price rise, but a fall is very likely medium term…
Looking through the short term challenges posed by the sharp rise in oil prices for 2008 and 2009, one key question for the medium term has to be to what extent real and nominal oil prices may fall once energy efficiency inducing technical change gets underway, reducing oil demand. Moreover, the fall in oil demand is not because of weaker growth but is in fact consistent with stronger growth (see charts b and c on real oil prices and economic growth), as the real cost of oil as an input in the production process falls. However, that is not a question we try and tackle here; rather we concentrate on whether oil prices may continue to fall further next year from recent peaks and what effect this may have on economic growth.

…however recent rise will lower economic growth path this year and next as global interest rates are raised to head off inflation threat
Oil price rises impact an economy in a number of ways. The first is that it takes income away from oil consumers and gives it to oil producers. This tends to weaken economic growth because personal consumption is greater in the developed countries while most oil exporters are than in the developing world. Second, higher sustained oil prices push up fuel prices and costs and so price and wage inflation leading to higher interest rates. Of course, some of the negative effects of the fall in economic growth associated with higher oil prices stem from an increase in official interest rates in response to the actual or perceived threat of higher inflation from the rise in oil prices. This makes the negative growth effect of a rise in oil prices larger than if there were not a monetary response. However, inflation could end up even higher and the output loss greater if official interest rates are not raised, as it could build in higher inflation expectations in the economy, especially if the response is delayed too long.

However, in the period since 2000, it is noticeable that the effect of a rise in oil prices either on growth or inflation has not been as great as the past experience since 1980 would suggest, see table 1. Oil prices averaged $26.3 a barrel in 1980 to 1989 and growth was a strong 3.3% per year. A fall to $17.5 a barrel in the next decade coincided with weaker growth, 2.5% a year, and a rise to $47.3 a barrel in 200-07 saw growth only weaken marginally to 2.3% a year. A similar story can be seen in average consumer price inflation trends in the periods, with a progressive fall from 5.5% in the 1990 to 1999 period to just 2% in the period 2000-2007.

Our view is that this could have been because of a cushion of strong productivity and lower oil per unit of output built up during the long period of very weak real oil prices. This includes the emergence of the developed economies that have taken a bigger share of world growth and who had more scope to absorb cost increases given their faster productivity gains. Moreover, the effects of better ‘policy’ – monetary and fiscal in the last decade or so - in keeping down price expectations, and faster growth in real incomes in the developing economies - has also minimised the economic effects of oil price rises. But this is now under threat as oil prices have risen to record highs and policy must respond. This response is already occurring with interest rates being raised in most parts of the world. The question is whether the world economy will have a recession as a consequence in 2009.

World growth has been very strong in the last decade and this has been a cause of higher oil prices and a consequence of how low they have been…
Before assessing the risk of recession, it is worth noting that the last 10 years have been remarkable for the world economy, with growth reaching the highest sustained pace since the 1970s. World growth has been running at 5% a year for the past five years, the fastest in any similar period of the past 40 years. This has pretty much been the case for all the major regions of the world, but in particular the emerging markets. A number of reasons account for the latter – more open markets, better economic management – but lower oil prices seem to have played an important role as well. But the recent rise in oil prices does pose a serious challenge to this performance, as faster growth seems to partly account for the recent surge in oil prices. A shift in the share of global growth from the developed economies to the developing would explain the recent rise in oil demand and imply a rise in real oil prices, even though the faster growth may mean the latter can absorb those price rises more easily. However, this rise in real oil prices has coincided with another side-effect of fast growth in the developing economies; namely, a strong rise in food prices. This latter seems likely to have a bigger impact on income and inflation in the developing economies than even the rise in oil prices, because of the larger share of food in indices of inflation and spending in poorer countries.

…but with oil prices already falling back, there could be a boost to global growth in the year ahead
World growth is therefore expected to slow in 2009 as a consequence of the policy response to higher oil prices this year but not to enter recession territory. The growth momentum is simply too strong in the emerging markets, as they attempt to catch up with the developed countries. Another reason is that oil prices are already falling back and are likely to drop further in real and nominal terms during the year ahead. Chart d and e show that if oil prices fall back to an $80-100 a barrel range, this will boost global growth and lower inflation. Interestingly, the UK economy will also benefit powerfully from any fall in oil prices. Chart f shows that UK growth rises and falls along with the changes taking place in the price of oil. This pattern suggests that the UK economy will see weak growth this year and next but it should accelerate through 2009, see chart f, especially if the oil price falls back as expected.

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Published on  Tue, Aug 19 2008, 07:14 GMT