How shocking? THE outlook for the global economy seems too good to be true. In its World Economic Outlook, published this week, the IMF forecasts that the world economy will grow by 4.7% this year and 4.2% next year�the fastest two consecutive years of growth since the mid-1980s. The IMF expects the rich industrial economies to slow from 3.9% to a still robust 3.0%, as America experiences (fingers crossed) a soft landing. What might upset this rosy picture? The most likely candidate is oil. In America this week, the price of oil hit almost $38 a barrel, more than three times its level at the end of 1998. The northern hemisphere is now moving towards winter with oil stocks at historically low levels, so there is a strong risk that prices could yet spike above $40 a barrel. European road hauliers are up in arms, but how worried should we be about the impact of higher oil prices on the world economy? The IMF�s latest forecasts assume that oil prices average $26.50 a barrel this year and $23 in 2001. Suppose that oil prices drop back a bit, but still average $30 a barrel next year. Using the IMF�s oil-price ready-reckoner, this 30% rise in oil prices from the base forecast would reduce GDP growth in the rich economies by little more than 0.3 of a percentage point; inflation would rise by 0.6%. Growth in oil-importing emerging economies, notably in Asia, would fall more sharply because they use more oil per dollar of GDP. All in all, global growth rates would be dented by around half a point next year. The apparent conclusion is that even if oil prices stay high, there is little to worry about. The OECD appears to be even more relaxed about the impact of oil prices. It suggests that even a $10 (or roughly 50%) increase from the level assumed in its base forecast, would reduce growth in the rich economies by around only a quarter of a percentage point. However, as with all economic forecasting, there is no magic formula which automatically calculates the impact of changes in oil prices. Economists have at least progressed since the first oil shock in 1974, when many were perplexed by the whole notion of stagflation. How could a rise in oil prices be both inflationary (raising prices) and deflationary (reducing demand)? Today, they understand better the various channels through which oil prices affect the economy. � An increase in the oil price delivers a �negative supply-side shock� to the economy�the exact opposite of the �positive supply-side shock� that information technology is said to deliver. Higher oil prices increase firms� input costs, so they produce less at any given price. If aggregate demand is unchanged, this means that prices rise and output falls. � Higher oil prices transfer income from oil-importing economies to oil exporters. This reduces the spending power of consumers and hence growth in output in oil-importing economies. The actual impact on global demand depends on whether oil exporters save their windfall or spend it on imports. � Headline inflation is boosted by higher fuel prices almost immediately. If higher inflation then pushes up wage settlements, the core, or underlying, rate of inflation will also rise. Assume a can-opener Economists may have better models than a quarter of a century ago for analysing the impact of oil prices on economies, but their forecasts are only as good as the assumptions on which they are built. One crucial assumption is how quickly the oil-exporting economies recycle their extra oil revenues by importing more from the rest of the world. The OECD ambitiously assumes that OPEC members spend 80-90% of their windfall on foreign imports within two years. That may be too optimistic (the IMF assumes a lower figure), because many oil exporters have budget and current-account deficits and so will be wary of embarking on a spending spree. A second assumption concerns whether higher headline inflation feeds through into wages. This depends both upon the tightness of labour markets and their flexibility. The more flexible real wages are, the less will be the impact of oil prices on core inflation. The good news is that labour markets in most rich economies are now more flexible than two decades ago. This, in turn, is linked to a third key assumption: how will central banks respond? If they leave interest rates unchanged, allowing real interest rates to fall, this will cushion the initial impact on output, but at a possible risk of higher inflation later, and hence eventually a sharper slowdown. If, as the IMF and the OECD assume, central banks instead refuse to accommodate higher oil prices and raise interest rates in tandem with inflation, then there will be a bigger short-term fall in output. Last but not least, most oil-price ready-reckoners assume no change in financial markets. However, if worries about oil prices and profits caused overvalued stockmarkets to tumble, households and firms would reduce their spending, exacerbating the slowdown in growth. The actual impact of oil prices is sensitive to any of these four assumptions. No wonder economists have consistently underestimated the impact of each of the previous three oil-price hikes. Some analysts even argue that the rise in oil prices is good news, not bad, because it will reduce consumer purchasing power and so help to slow the American economy without the need for higher interest rates. This view not only ignores the likely increase in America�s trade deficit, which rose to record levels in July, but it also assumes that higher headline inflation will not push up wages. Yet in a squeaky tight labour market (which is precisely why a slowdown in growth might be good news) that smacks of wishful thinking. The economic impact of higher oil prices will almost certainly be less this time than it was in the past. The rich industrial economies use only half as much oil per dollar of GDP as they did in the early 1970s. And even after the recent increase, the real price of crude oil today is still less than half its level in 1980. The oil-price hikes in 1974 and 1980 both transferred from oil importers to OPEC economies the equivalent of around 2% of GDP. This time, if prices averaged around $30 a barrel, the income loss to rich industrial economies might be equivalent to just over 0.5% of GDP. To trigger a repeat of the 1970s oil crisis, the price would have to rise to $70 a barrel. Now that would be a shock. _______________________________________________ Crashlist resources: http://website.lineone.net/~resource_base To change your options or unsubscribe go to: http://lists.wwpublish.com/mailman/listinfo/crashlist
