RIYADH, 23 August 2004 — Oil prices set off alarm bells last week as the benchmark US crude oil contract (WTI) neared a record $50 a barrel in New York, but financial markets were unfazed and, in fact, closed positive for the first time in the last three weeks. Despite months of scare — first $30, then $40 and now almost $50 a barrel oil prices — the global economic recovery has not yet been derailed. Some US economists are now even beginning to say that high oil price may be an economic stimulus in disguise!
Pardon me, how does that work? The main difference between the 1970s, 80s and 90s when high oil prices did start global recessions, and now, are three. First, in real terms, oil prices are still nowhere near they were in the 1970s, for example, when they were equivalent to around $80 a barrel in today’s dollar. Second, the US economy has become much more energy efficient than before.
Today, it takes 20 percent less oil to produce one dollar of gross domestic product than during the last (1991) Gulf War recession (despite booming SUV demand!). And, the third and most important difference from before is the behavior of inflation and the US Fed-driven interest rates. In the past, high oil prices would put the US Fed in a bind by putting pressure on inflation and depressing economic growth (i.e., stagflation) at the same time. If the Fed raised interest rates to cool inflation, it would force recession. If it tried to lower interest rates to keep economic activity, it would stoke further inflation.
This time around, high oil prices for over one year have not fueled inflation and it has not depressed economic activity. Overall CPI has been up only 3 percent this July over its year ago level, and, is only 1.8 percent higher excluding food and energy. This has so far allowed the Fed to raise short-term interest rates slowly while, at the same time not putting pressure on long-term interest rates to rise too fast. Economists can always be wrong, and this is not to say that continuing increase in oil prices will not eventually choke off growth (there is always a breaking point for any economy!). What is good though is that there are already some automatic countervailing (i.e., self-correcting mechanisms) at work that may yet produce a soft landing.
The so-far slowly rising long-term interest rates, the “measured pace” rise in US Fed short-term interest rates, and the cooling off of the steaming China growth machine — all together — means a gradual slowdown in the growth of oil demand in the months ahead, which, in turn, may slow down the pace of oil price increase, and, voila, the choke hold of ever-rising oil prices on the economy maybe dampened.
In other news, global economic indicators show uneven results. Japan, France, Germany and the UK showed some upbeat indicators, while data for the US were mixed. Meanwhile, most economists are deeply worried about how far the fall-off in China growth will go?
(Khan H. Zahid is chief economist and vice president at Riyad Bank. He is based in Riyadh.)