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Feeling the pinch from higher oil prices
>Published: September 3 2005 03:00 | Last updated: September 3 2005 03:00
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Away from the devastation and suffering of the US Gulf coast, the main impact of Hurricane Katrina
has been on oil and petrol prices. Crude touched an all time high of $70 a barrel and now hovers
around $67, while the extra premium for refined petrol has shot up. Investors would be wise to
ponder what this means for the world à Âeconomy.
If anyone had said back in January 2003 that the price of oil could increase from $30 to $70 without
severe economic consequences they would have been dismissed as insane. Yet this is what has
happened. The question is, should we assume that because the world economy has shrugged off high
oil prices to date it will continue to do so in the future? Answer: No.
We are now talking about an oil price spike comparable, though not equivalent, to the great oil price
shocks of the 1970s. During the first shock, from May 1973 to January 1974, the price of crude rose
325 per cent. During the second, from September 1978 to November 1979, it jumped 213 per cent.
During the latest episode, from September 2001 to today, it has increased by 292 per cent.
Granted, the price of oil was unusually low in September 2001, following the terrorist attacks of
9/11. But even taking January 2003 as the start date, oil has since risen 124 per cent. Adjusted for
inflation it is higher today than at any time outside the period 1979 to 1982. The main difference this
time round has been that the oil shock has come in slow motion, driven largely by demand pressures
along with concerns about production, rather than a one-off big reduction in supply.
The standard rule of thumb - based on an International Monetary Fund study five years ago - is that a
$10 rise in the price of oil knocks 0.5 per cent off global growth annually for the next four years.
This study allowed for the fact that developed countries now need less energy to produce a dollar of
output than they did in the 1970s.
Based on this rule, the $40 increase in oil since the start of 2003 should have knocked 2 percentage
points off global growth. Yet the world economy grew at a record pace last year. The US continues
to grow around trend, while the UK, while weaker, is still far from recession.
There are two possible explanations. One is that traditional rules of thumb exaggerate the impact of
oil (they probably do, but not by very much). The other is that countervailing factors were at work.
This is more plausible.
The original IMF study noted that if central bankers were able to ignore the effect of higher oil on
inflation, because other prices remained steady, the impact on growth would be halved. As people do
have greater trust in the ability of central banks to control inflation today than they did in the past,
the Federal Reserve and Bank of England in particular have been able to offset the loss of spending
power by setting interest rates lower than they would have been otherwise.
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FT.com / Home UK - Feeling the pinch from higher oil prices
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The other balancing factor was the wealth effect from asset prices. Since January 2003 property
prices in the UK and US have soared, with the US housing market up 26 per cent and still rising.
Shares have also powered up. The FTSE World equity index has risen by 53 per cent, with some
indices, such as the FTSE 250 index of UK stocks, hitting record highs.
Neither of these counterbalancing factors can be expected to hold as strongly going forward.
Property prices have already flattened out in the UK, accompanied by a sharp dip in consumption.
Alan Greenspan recently warned on house prices in the US. Moreover, as core inflation creeps up quite rapidly in the UK - central bankers will find it harder to ignore the effect of oil on inflation, lest
they jeopardise their credibility. As oil scales fresh heights, there may also be additional damaging
effects on confidence.
All this suggests that oil will bite more painfully in the months ahead. This will hit consumption and
growth in all big economies. But the biggest victims are likely to be emerging markets and other
developing countries that import oil. They no longer benefit from a compensating rise in other
commodity prices. Expect jitters in emerging market debt and possible balance of payments crises in
the poorest oil-importers in the months to come.
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