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September 9th - 15th 2000

Poised to strike? SUFFERING from a touch of dij` vu? Oil prices have more than tripled since the end of 1998; political leaders, including Bill Clinton, are appealing to OPEC countries, whose oil ministers are meeting this weekend, to increase production; France has seen the return of long queues at petrol stations, as road hauliers protesting about fuel prices block supplies (see article). Such news brings back scary memories of the three previous big oil-price shocks, in the early and late 1970s, and in 1990. On each of those occasions, when oil prices also roughly tripled, inflation duly rose and the world economy slipped into recession. Yet, oddly, hardly anybody seems worried about such a prospect todaynot least investors, who have been pushing share prices towards new highs in many stockmarkets around the world. Oil no longer matters, they seem to believe: the new economy runs on information and silicon chips. But, although there is no cause for panic about oil prices, this view looks terribly complacent.

At first blush, the complacency seems understandable. The world economy has rarely looked in better shape. This year it is likely to enjoy the heady combination of the fastest growth for 16 years and the lowest inflation for 30. But at such times it is always prudent to ask: what might go wrong? And one answer is sticky and black, and hit a ten-year high this week of nearly $35 a barrel. At this weekends meeting, OPEC ministers are likely to agree to raise production quotas, but this is unlikely to have much short-term effect on prices (see article). American oil stocks are at a 24-year low, there is a lack of spare refining capacity, the world economyand hence demand for oilis booming, and the northern hemisphere is heading towards winter. Indeed, there is a risk that, no matter what OPEC does, oil prices could spike above $40 a barrel, especially if the winter proves severe. In the long term, oil prices are likely to fall: high prices and new technology will reduce demand and encourage exploration. But in the short term, oil prices may well stay highand that could be enough to do serious damage to the world economy.

There are, admittedly, good reasons to expect the impact of this oil-price shock to be less severe than its predecessors. For one thing, the recent tripling of oil prices followed a sharp drop. In real terms, prices are still one-third below their level in 1990, when Iraq invaded Kuwait, and half their level in 1981. Investors are also right to believe that oil now plays a smaller role in the economy. Thanks to energy conservation, a switch to other fuels and a shift in the composition of output from heavy industries to services, rich economies use only about half as much oil for every dollar of GDP (in constant prices) as they did in the early 1970s. A higher oil price has a correspondingly smaller impact on inflation and output in those countries. Lastly, in comparison with previous oil-price shocks, when economies were already overheating, inflation is currently more subdued.The Economists non-oil commodity price index has barely budged over the past year.

But even if oil is less important in the new weightless economy, that is a far cry from saying that it does not matter at all. If they last for long enough, higher oil prices will certainly hurt oil-importing countries. As a rule of thumb, the OECD reckons that a $10 increase in the oil price, sustained for a year, lifts inflation in rich economies by half a percentage point after a year, and reduces growth by a quarter point. Moreover, although rich countries may be less dependent on oil than they were, many oil-importing emerging economies now use more oil per dollar of GDP than in the 1970s, thanks to rapid industrialisation and rising car ownership. A sustained rise in oil prices could set back the recovery in emerging Asian economies, in particular.

Fuelling inflation

The full impact of higher oil prices depends in part on how policymakers respond. There seem to be striking differences in attitudes towards higher oil prices between Americas Federal Reserve and the European Central Bank. The ECB has raised interest rates as oil prices have pushed headline inflation above its medium-term target of 2%. In contrast, the Fed has held rates unchanged for the past four months, even as its headline inflation rate has jumped to 3.5%. Central banks have to weigh two opposing forces. On the one hand, higher oil prices push up inflation; on the other, they act as a tax that squeezes real incomes (and hence consumer spending), thereby muting underlying inflationary pressures. The more serious the risk that higher inflation will feed into wages and trigger a wage-price spiral, the more urgent it is that a central bank raises interest rates. That is why the ECB was right to raise rates last week. The Fed, however, seems to fret less about headline inflation, and focuses instead on core inflation, which excludes energy prices and has accordingly risen by much less.

The Fed believes that wages are less responsive to headline inflation in America than in Europe. If the jump in oil prices proves temporary and inflation comes down next year, this may well turn out to be correct. But it is adding to the risks it is already taking. In not raising nominal interest rates, it has allowed real interest rates to fall, which seems hardly suitable for Americas steaming economy. Americas labour market is already squeaky tight, so wage demands could start to follow headline inflation more closely than in the past. The cost of holding rates down now may be higher ratesand a sharper economic slowdownnext year.

It is worth recalling that economists have repeatedly underestimated the impact of previous oil shocks. For instance, in December 1990, after oil prices had soared, the OECD forecast growth in rich economies for 1991 of 2%; in the event growth turned out to be only 0.8%, as America and other countries dipped into recession. Alarmingly, some economists are now arguing that higher oil prices may even be good news for the American economy (and for Wall Street), because they will help to slow consumer spending and so reduce the need for higher interest rates.

This may partly explain why share prices are rising yet again. And here lies the biggest risk of all. Even if the direct impact of higher oil prices is more muted than it once was, they may prompt even the most fervently bullish investors to notice such things as Americas gaping current-account deficit and dismally low saving rateand to realise that there is still such a thing as bad news. That might just be the trigger for a long-overdue slide in share prices. The effects of that would be far more widespread than higher petrol prices.

http://www.economist.com/2r3r8Frt/editorial/freeforall/current/index_ld0292.html

-- Martin Thompson (mthom1927@aol.com), September 13, 2000