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Greasing the wheel

27 January 2015 By Andy Mukherjee

A sharp oil price decline is generally a sign of oversupply, and an oil glut is normally an economic lubricant. The oil price is down almost 60 percent since June, and about half of the decline looks like a case of oversupply. But cheap crude might not provide much oomph, because central banks are gumming up the works.

Of course, oil may not be cheaper merely because there is too much of it. Some economists think that the decline in crude prices in the second half of 2014 is primarily because of weak demand. If they’re right, the excess of crude will do nothing fast to propel GDP growth.

But judging by the way that the fall of oil has filtered into other prices, it looks like the gloomy crew have it backwards. Compare the recent collapse in oil to the similar drop in the first half of 2009. Then the financial crisis led to a sudden and dramatic collapse in demand for oil and everything else. About half of this commodity-led drop in headline inflation immediately filtered through to the core inflation rate, which is calculated by stripping out volatile food and energy prices.

This time around, only about a quarter of the drop in headline inflation has seeped into core prices, according to a Breakingviews analysis of price trends in 25 major world economies, which between them account for $65 trillion of output.



In other words, the disinflationary drag from weak demand is only half as strong now as six years ago. That suggests that the other half of the oil price fall comes from unexpected excess supply – such as Saudi Arabia’s decision to keep production intact amidst stumbling prices. If that is right, the supply shock, as economists call it, is potentially large enough to give a nice potential economic push in importing nations.

The cost savings from cheaper oil will allow households to buy more of other things. Governments in poorer oil-importing countries will spend less on energy subsidies and more on infrastructure, as Indonesia has already started doing. Oil exporters will suffer, but world output will get a boost. Simulations by International Monetary Fund economists Rabah Arezki and Olivier Blanchard suggest a 0.4 percent to 0.8 percent increase in global GDP in 2016 from what it might otherwise have been.

However, there are problems. Resources companies are cancelling investment plans and cutting production where they can. This could have ripple effects on jobs and wages. Meanwhile, animal spirits in non-resources industries are being held back by the inability of central banks to fix the banking motor. And while global demand is not collapsing, it is too low to encourage investment and consumption.

Worse still, even the subdued drop in core inflation that the world economy has witnessed in the past six months is surreptitiously pushing up the real, or inflation-adjusted, cost of borrowing. That, too, can be blamed on central banks’ helplessness: nominal interest rates in rich nations are at rock bottom, and can’t be cut any further.

The other strategy for monetary easing is quantitative easing, or bulking up of the monetary authorities’ balance sheet. This device, which is already looking worn from overuse, is getting pressed into service in the euro zone. But the Swiss National Bank has abruptly turned off the money-printing machine, and the Bank of Japan is finding it hard to crank it up. As QE fatigue weakens investor expectations of future inflation, businesses could become even more nervous to order new plants and machines.

If China and India don’t cut interest rates aggressively this year, and if the United States raises them, the global inflation-adjusted cost of capital could increase further. That could be problematic, particularly in Asia. From China and South Korea to Thailand and Malaysia, companies and households have loaded up on so much of debt in the past few years that their capacity to service the loans is now stretched. If disinflation leads to higher real interest rates before it can jumpstart consumer spending and GDP growth, the potential gains from the oil glut would be squandered.


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