Global stagflation on the cards amid oil crisis threat

Events in North Africa and the Middle East, along with the build-up of inflationary pressures, have finally started to disturb the financial markets’ complacent confidence that global growth will inevitably accelerate.

Share prices have fallen only slightly from their recent highs and remain at elevated levels that can only be justified if you are prepared to shrug off mounting risks, but the earlier upward momentum is now facing growing resistance. The cheerful mood is increasingly being mixed with a much-needed dose of scepticism.

The possibility that things can go wrong is not yet the dominant view, but it is no longer dismissed out of hand. Market reaction to the US labour market figure, a key monthly indicator, illustrates the more sombre mood. The weak and disappointing January employment report was shrugged off and share prices continued to rise, but the much stronger February employment figure was given a cool reception, and both the stock market and the US dollar weakened.

The financial markets believe that the new risk of a global oil shock is a major concern.

Over the past six months, oil prices have increased by almost 50 percent. Political turmoil has accelerated the pace, but crude prices have been moving up sharply for economic reasons even before recent events raised fears about oil supplies. Even without major disruptions, there is a risk that much higher oil prices will produce an unpleasant mixture of weaker growth and higher inflation. The GDP forecast shown in the table below is based on the assumption that the oil price (using Brent crude as the benchmark) will average some $100 a barrel. Even if Brent crude rises to $120 a barrel, the global recovery will probably continue, albeit at a slower pace. But much larger price increases, to $150 a barrel or higher, will undoubtedly cause a major setback. The risk of global stagflation is now much greater.

Central bank response

The differences of opinion between the major central banks on how to react to higher inflation are intensifying. In Asia, growth in many economies remains too fast and monetary policy will be tightened further. China has increased interest rates twice in the last three months, and has repeatedly raised bank reserve requirements to restrain lending. Many other developing Asian economies such as Indonesia, India, South Korea and Vietnam have also raised rates. At the other extreme, Japan was still facing deflation before its devastating earthquake and tsunami and had said it would continue keeping rates at just above zero for some time. But the policy gap between the US and Europe is becoming more acute.