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Lower Crude Prices Could Prolong Deflation

Lower Crude Prices Could Prolong DeflationLower Crude Prices Could Prolong Deflation

Without oil, the global economy would grind to a halt – even with the advent of alternative energy sources. But although it is tempting to think that declining oil prices always boost global economic activity, the story is rather more complicated.

While there is evidence to suggest today’s lower oil prices reflect some beneficial supply-side shocks – increased US production and an OPEC cartel fraying at the edges – it is impossible to ignore the role of weakening global demand too: lower oil prices are partly a reflection of broader deflationary trends, a report published by HCBC suggested.

A supply-driven decline in oil prices is likely to be a positive for the global economy in aggregate. A demand-driven decline is likely to be a sign of a deeper malaise. The recent fall in oil prices appears to contain elements of both, even if we cannot yet determine the relative weights.

Moreover, lower oil prices are typically associated with periods of sustained monetary easing, starting with the Federal Reserve in Washington. However, even though a period of lower inflation could eventually persuade the Fed to delay the widely expected monetary tightening in 2015, there simply isn’t room for the rate cuts seen in the 1980s and the 1990s.

As a result, the consequences for other asset classes are uncomfortably ambiguous. Households and companies may choose to use their real-income windfall gains to repay debt rather than to increase consumption or investment.

Some emerging economies may be faced with sizeable adjustment difficulties: oil price declines have been matched by falls in other commodity prices, leaving the world’s commodity producers in a more parlous state. And, in the absence of Fed easing, balance of payments positions could prove more difficult to finance.

There are exceptions though. As major energy importers, India and Turkey stand to benefit while Saudi Arabia, Kuwait, Qatar and the UAE have reasonably healthy public sectors and national balance sheets, thanks to the many years of accumulated surpluses.

But for dealing with deflation, lower oil prices will complicate the messaging coming from central banks. Lower oil prices are both a blessing and a curse: they may boost real incomes, similar to an indirect tax cut, but they may also reinforce expectations of a continuously falling price level.

The Bank of Japan has expressed its determination to push inflation back up to 2% but, as a major oil consumer, lower oil prices will make progress that much more difficult. The European Central Bank may struggle to convince sceptics that the risk of deflation has been lifted if oil prices continue to drop and, as a result, more and more Eurozone countries succumb to a world of falling prices.

At the very least, there could be heightened currency volatility. At worst, there could be policy mistakes. After all, if the reasons behind the oil price decline are ambiguous, the consequences for the global economy will remain uncertain for months to come. Under those circumstances, crude hope will be trumped by complicated reality.

Financialtribune.com