Could a supply shock give a temporary boost to economic activity in the advanced countries?
The price of oil is naturally very sensitive to the supply/demand balance. The combined factors of supply and demand account for the falling per-barrel price of oil that began last autumn.
On the demand side of the equation, the changing demand for energy commodities must be distinguished from developments in world trade (which itself is very closely tied to global GDP). Over the past few years, we have seen a downturn in global demand for oil and an increase in supply (mainly due to shale gas development in North America). Lower demand
for oil does not come from weaker aggregate demand for goods. In this respect, the situation today is very different from that of 2008-2009. At that time, the plunge in the per-barrel price of oil of the same magnitude was due to collapsing world trade. But today we are seeing nothing of the sort: world trade continues to grow at an annual rate of 3.5%. Admittedly, global industrial output has declined recently (with a very noticeable downturn in China) but it is far from going into free fall (see chart 1). Lastly, the Purchasing Managers’ Index (PMI) surveys, aggregated to represent global activity, point to continued global economic growth that is very likely to remain above the symbolic threshold of 3% in 2015.
In fact, the slowing demand for energy commodities is attributable to the gradual maturation of production processes in emerging countries and their increasing efficiency. The same trend was noted in developed countries after the oil shocks of the 1970s. The resulting “demand shock” is driving down the price of oil but it is quite different from the generalised shock that hit the demand for goods and sent energy prices tumbling in its wake (2008-2009). To some extent it can be argued that as regards spillover effects on the global economy, this demand shock looks more like some kind of positive supply shock.
A shock to reshuffle the deck
Of course, there are winners and losers. Lower oil prices are having tremendous redistributive effects (from sector to sector and country to country). Net exporters of commodities, most of them emerging market economies, have been hit by a negative shock (lower export earnings and declining tax receipts). On the other hand, for most developed countries –all of whom are net importers of commodities– falling energy prices is supporting economic activity. Even in the United States, it is estimated that the positive effect (households, businesses in the non-energy sector) continues to dominate notwithstanding the growing importance of shale gas development over the past five years.
Even so, it’s not a zero-sum game. The substantial share of global GDP accounted for by net importers of oil still outweighs that of exporting countries; lower oil prices brought on by oversupply (or shrinking demand linked to the maturation of production processes) are therefore having a stimulating effect on global activity. The transmission channels are well-identified. Lower oil prices are increasing the purchasing power of households. Businesses are seeing their profit margins improve. In a “normal cycle”, the benefits would be expected to flow to household consumption and capital spending. However, the gains are at best temporary. Once per-barrel oil prices stabilise, the stimulating effects will then fade over time (within two years). In the short term (the first year), a positive chain of events is far more likely to materialise if consumption and investment have been dampened ahead of time. Ultimately, everything depends on global macrofinancial conditions and the point in the economic cycle. In this respect, the United States and the eurozone find themselves in very different situations:
1 The low tax on petrol at the pump (relative to Europe) amplifies price fluctuations as price of crude evolves. Furthermore, the weight of this expenditure item in US household budgets accentuates the impact of petrol price fluctuations on consumer demand for other goods and services.
The oil shock will stimulate global growth
There are winners and losers. But it is not a zero-sum game
Economic prospects have not been revised upwards by any measurable extent so far
Without denying the expansionary nature of the oil counter-shock, most economists (the consensus view) remain cautious about the size of the stimulus: the world outlook for growth was just revised in the past few months. There are a number of reasons for this.
To put it simply, it is not the broadly expansionary impact that is being called into question but rather its size, especially in the economies of the eurozone because of the deflationary environment.
Deflation: price indexes and inflation expectations can be misleading
One of the more prominent arguments about falling oil prices is that they will add to deflationary pressures in the eurozone. It is clear that when energy prices massively decrease – as was the case in 2008-2009 or since autumn 2014 – shortly thereafter headline inflation follows suit and slips into negative territory. This is strictly cause and effect.
But we should not get the wrong idea about the nature of this particular kind of deflation. Not all price declines are created equal: some can be positive for aggregate demand (this is especially the case for commodities, as we have just seen) while others – further lowering of wages when low wages prevail or a further decline in the price of goods when prices are falling – can trigger a deflationary spiral resulting in a drop in aggregate demand...and in asset prices (equities and real estate).
Furthermore, inflation expectation metrics are rarely accurate predictors of future inflation. Experience has shown that expectations are often “naive” (i.e. unreasonably correlated to actual inflation). In recent years, diminishing inflation expectations (in surveys of households or in market expectations) can be explained mainly by falling oil prices. However, even when there is a long-lasting shock to the per-barrel price of oil, there is no reason to revise inflation expectations downwards.
In short, temporarily negative inflation should not be confused with deflation.
...but even so, deflationary pressures should not be underestimated.
In fact, real deflationary pressures are not directly linked to fluctuating energy prices. Neither the consumer price index nor surveys reflect their intensity properly. The core inflation trend (excluding food and energy) provides a more accurate picture. In recent months, core inflation has settled at an exceptionally low level in the eurozone (0.6% yoy in January 2015).
2 It is estimated that every $10 decline in the price of oil equates to a 0.2 percentage point (pp) increase in the growth of OECD countries. In other words, all things being equal, the growth outlook should have been revised upwards by 1 pp since last autumn.
Temporarily negative inflation should not be confused with deflation
The real deflationary pressures have no direct link to fluctuating energy prices
To better understand the dynamic effects of deflationary pressures in the eurozone and their origin, we consider the weight progression of components that have risen less than 1% over a one-year horizon in the core consumer price index (core HICP) (see box).
It comes as no surprise that the swiftest spread of deflationary pressures occurred in the countries on the southern periphery of the eurozone (Spain and Italy). In Spain, it is striking to observe that the economic recovery barely managed to stem the spread of deflationary pressures. Unsurprisingly, the continuing recession in Italy over the course of 2014 caused the spread of such pressures to accelerate. In France, the economic stagnation of the last three years was accompanied by a slow increase in deflationary pressures. Of the four largest economies in the eurozone, only Germany’s economy has been spared.
This assessment is borne out by a careful analysis of certain expenditure items. As expected, price trends in the non-durable industrial goods sector confirm (1) the intensification of deflationary pressures in the eurozone in the past 12 months and (2) that France is worse off than Germany (see chart 6).
Slowing inflation: a problem of aggregate demand
These deflationary pressures have no direct link to fluctuating energy prices. They are mostly tied to the economic cycle and are ultimately rooted in the same causes as high unemployment. We saw them develop in the eurozone after the shock of the Great Recession. As inflation is a latent indicator of economic activity, the “deflationary pressure peak” occurs several months after the end of the recession (See box). The example of Spain demonstrates that several years of robust growth across the eurozone are required to sustainably curb deflationary pressures.
In spite of the 2014 recovery, the level of private domestic demand remains below its 2009 high (see chart 7); in other words, excess capacity persists. It is notsurprising to see that deflationary pressures have increased in the eurozone over the past two years. Many countries have fallen into the trap of high unemployment and low inflation. It is striking to observe that even the German economy, although close to full employment, is experiencing excessively low inflation.
The virtue of QE is that it loosens all monetary and financial conditions
The weaker euro, falling interest rates (in particular on bank loans to SMEs) and rising equity prices amount to a loosening of monetary and financial conditions whose impact on the economy will become clearer six months from now. The easing of fiscal policies is also a supportive factor of growth. We are already seeing a turning point in the eurozone economy with the restoration of confidence and early indicators of accelerated growth at the beginning of the year. In an environment where monetary and financial conditions are highly accommodative, falling oil prices are more likely to stimulate demand than to encourage savings. To put it simply, far from being inflationary, lower oil prices may ultimately prove to be reflationary due to the stimulative effects on aggregate demand3.
The most dangerous situation for any economy is not one where the prices of some goods and services are falling, but one where falling prices are becoming increasingly commonplace, pulling earnings, aggregate demand and asset prices along in their wake. It is the likelihood of such a scenario that is fading in the short term (2015-2016).
That said, it should not be forgotten that several years of robust growth are needed to permanently curb the deflationary pressures at work. The effects of loosening money and financial conditions and of falling oil prices are essentially temporary. But it is still too soon to tell whether a virtuous and sustainable cycle of reflationary recovery is underway in the eurozone.
3 And hence secondary effects on oil demand (the price of oil may advance slightly, pulling inflation expectations along in its wake).
Over two years of robust growth