Petrol could get to $2 a litre and that may be the straw that breaks the economy's back


September 18, 2019 11:57:38

For years central banks across the developed economies have fought with just about every weapon in their arsenal — and even some they didn’t previously know they had — to try to boost inflation.

Over the past three decades, it has become conventional wisdom that there is a healthy level of consumer price increases — inflation — compatible with a sustainable speed of economic growth.

If prices rise faster than this healthy level, which is widely assumed to be somewhere between 1-3 per cent in the advanced economies, then it’s a sign that the economy is growing faster than its capacity constraints, like the availability of workers or materials, and needs to slow down.

That is when central banks will typically raise interest rates to cool things down — if interest rates are higher, there is generally less borrowing and spending, with more saving.

If price rises are below the target, it is seen as a sign the economy isn’t using all the resources available to it and could grow more quickly, so central banks will cut rates.

The problem is price rises have been low in many advanced economies — most notably Europe and Japan — for years, or even in Japan’s case decades, without low, zero or even negative interest rates doing much to boost them.

Oil supply disruption ‘worst in history’

But that could be about to change, and not in a good way.

The aerial attacks on key Saudi oil facilities have temporarily knocked out about 6 per cent of global crude supply.

The damage is going to take weeks to fully repair, there is a risk of further attacks and analysts say there is only a limited extent to which global stockpiles or increased production elsewhere can offset the shortfall.

“OPEC’s spare capacity of around 4mbd [4 million barrels per day] is reasonable but less than the outage from Saudi Arabia, and there are ongoing issues in terms of supply from Venezuela and Libya,” AMP Capital’s chief economist Shane Oliver noted.

Oil markets reacted strongly to the disruption, with prices jumping about 20 per cent from $US60 to nearly $US72 a barrel when they had their first chance to respond on Monday.

They have come back quite a bit since then, to about $US64 a barrel, on news that most of the disrupted oil production will be back online within two to three weeks.

However, most analysts expect prices to remain above previous lows on increased worries about further attacks.

While Monday’s 20 per cent surge may sound like a big jump in prices, Dr Oliver said it was a pretty subdued response by historical standards.

“The 5.7mbd disruption makes it the worst in history — worse than the Iranian revolution (5.6mbd) that saw a roughly threefold increase in oil prices and the Iraqi invasion of Kuwait (4.3mbd) that saw oil prices briefly double,” he wrote.

“So a further spike in prices is likely if the threat continues to escalate.”

The threat isn’t going away, with discussion of war still live in Washington.

Economic fallout from oil price shock

So there’s a pretty high chance oil prices will rise further from here, not slip back to recent lows.

What effect would that have on already struggling global economies?

“Past oil price surges have clearly played a role in US and global downturns — in the mid-1970s, the early 1980s, the early 1990s, early 2000s and even prior to the GFC [global financial crisis],” Dr Oliver said.

He added it generally took a doubling in oil prices over 12 months to have those recessionary effects, which would require Brent crude hitting $US120 a barrel — and we haven’t been close to those levels for five years.

The analysts at Capital Economics think that kind of price rise is unlikely, but not impossible.

“We would not rule out entirely the possibility of an escalation in tensions, leading to an outright conflict in the Middle East,” they noted.

“In that case, we would not be surprised to see oil prices reach, and perhaps even rise above, $US150 per barrel by end-2019.”

But research from Citi’s global economics team suggests even a $US10-a-barrel increase in prices, which was briefly exceeded on Monday morning, would cause a slight slowdown in global economic growth and a meaningful jump in inflation.

Economic modelling suggests even such a modest price increase, if sustained, might take about 0.1 percentage points off global growth and add 0.9 percentage points to inflation.

Welcome to a central banker’s nightmare

This is a central banker’s nightmare.

Most of them would normally welcome that inflation increase with glee, but this would be one driven by a negative supply shock rather than a demand pull.

A demand pull happens when the economy is growing faster than its capacity in workers and resources, and it should be able to cope with higher interest rates to take a little heat out.

A central banker’s problem with negative supply shocks in an important commodity such as oil is that they can catapult inflation well above the bank’s target but at the same time lower economic growth.

Oil price rises are particularly insidious as they infect the economy both directly and indirectly.

For a start, households pay more for petrol, leaving them with less to spend.

Dr Oliver said a doubling of crude oil prices from recent lows would take Australian petrol prices from around $1.40 a litre to $1.95, pushing the average family’s fuel bill up by $19 a week.

But the effect of higher fuel prices reverberates throughout the economy.

Transport costs rise, increasing the input costs of many businesses, forcing those that can to raise their prices, and those that can’t to cut other costs (like wages or investment) or accept lower profits.

‘Stagflation’ risk from oil

If fuel costs rise enough, the economy could find itself in a state of “stagflation”, where the economy is stalling or in recession but inflation is high.

This is what happened in the 1970s, when the cartel of oil-producing nations, OPEC, cut production to boost prices.

It leaves central banks with inflation above their target levels but economies that need more stimulus, not less.

The inflation target is screaming for them to raise rates, but the economy is crying out for further cuts.

The Bank of France governor Francois Villeroy de Galhau is not yet alarmed, but he is alert to the risks.

“It is too early to rush to hasty conclusions; we should closely monitor the consequences on the oil market, which is characterised by a rather flexible supply and a subdued demand,” he said in a London speech.

“If it lasts, this latest oil shock could increase inflation and hamper growth.”

Dr Oliver doesn’t think it’ll be a problem this time around.

“While higher oil prices boost inflation, central banks will ultimately look through this as it’s seen as a one off, and ultimately less consumer spending power weighs on underlying or core (i.e. excluding energy and food prices) inflation,” he argued.

“So a spike in oil prices is unlikely to stop further central-bank easing as we saw in the early 1990s, early 2000s and through the GFC.”

But even if the Reserve Bank looks past a temporary spike in inflation, the last thing it needs right now is another weight on an economy in which consumers aren’t spending, businesses aren’t investing enough, and only population increase is keeping the economy growing.

Both locally and globally, a genuine oil price spike could be the final straw that breaks the back of a post-global financial crisis expansion looking very long in the tooth.

And if oil prices do not end up sinking the global economy, Mr Villeroy de Galhau warned that, over the longer term, climate change might.

He warned it could create upward price pressures and a slowdown in activity which risks generating a “long-term stagflationary shock”.








First posted

September 18, 2019 05:01:34

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