Between April 2005 and April 2006, the price of a barrel of oil jumped from
$49.7 to $71.9, a rise of nearly 45%. Since no sector of industry or region of
the country is immune from higher energy costs, and because the transmission
mechanism is almost immediate (crude prices increase one month and petrol pump
prices usually respond within weeks), the impact was felt quickly across the
economy. And because energy including electricity, gas and water accounts
for 7.5% of the Consumer Price Index, there would be an impact on the overall
rate of inflation.
With energy prices increasing in annual terms by almost 20%, so the CPI as a
whole moved upwards, from under the 2% target in March 2006 to 3.1% a year
later. Not surprisingly, the MPC responded by raising interest rates, from 4.5%
to 5.75% in five equal instalments. This was as much to warn companies and
unions not to use higher oil prices as a reason to raise their prices or push
for higher wage settlements as it was to dampen the immediate inflationary
threat. From a peak of 3.1% in March this year, the CPI has now fallen for six
months and has been back within the 2% target rate for the past three months.
This may have been due to the rate rises, or to the fact that the annual rate of
energy price increases fell back to under 1%.
But are we now expecting a re-run of interest rate rises just when it seemed
that the inflationary threat has dissipated? Oil prices are soaring and are
currently on the verge of breaking through the $100 a barrel threshold for the
first time. This is after they had dropped to less than $60 in January. And, of
course, petrol prices are not far behind: £1 per litre in the UK is now a fact
of life. While the threat from energy prices is as potent as ever, the economic
background in autumn of 2007 is rather different from a year ago.
In the first place, there is far more uncertainty about the outlook for the
global economy in the coming months, which raises questions of whether the
current price is a new equilibrium or a short-term spike. There are grounds for
believing the recent jump in price does not really reflect the real
supply-demand balance. If, as seems likely, the US economy weakens, it will have
an impact on China, and slowing activity in the two major energy consuming
countries in the world will ease some of the pressure on oil demand, and
therefore prices. The slide in the US dollar not only reflects worries about the
US economy, but also makes the impact of oil price rises look worse than it
really is in sterling terms.
And there is, as ever, some speculation in the current price as equity
markets wobble in the wake of the sub-prime crisis investors have been turning
to oil. Apparently, trade in oil futures has been brisk. Political uncertainties
have always been a factor in the oil price. Turmoil in Iraq, tensions between
Iran and the west, unrest in Nigeria and even the devastating damage caused by
storms in Mexico have all had an impact.
So, the consensus view is that oil prices are at or fairly close to a
short-term peak. OPEC has agreed to step up production in November and several
non-OPEC suppliers will be tapping into new fields in the coming months. A
gradual increase in supply and a modest easing of demand should see oil prices
come off a bit. Hopes that they will drop to $60 to $70 a barrel are, however,
likely to be unfulfilled as the centre of global growth moves away from the
traditional industrialised countries of the west and to emerging markets, which
accounted for 60% of global growth in 2006. This is creating new sources of
For the UK, there is an obvious dilemma for the policymakers. The recent
percentage increase in oil prices comes close to matching the 2005-06 rise and
the policymakers are probably nervous that the impact on the CPI will be
similar. But where 12 months ago the MPC started to increase interest rates with
the economy growing strongly (GDP is currently growing at an above-trend rate of
3.3%), the prospects for the next 12 months are far more uncertain. Chancellor
Alistair Darling admitted as much in his pre-Budget report in October when he
scaled back the Treasury’s projections for 2008.
The emerging weakness in the highly-indebted personal sector and constraints
on government finances the two primary drivers of activity for the past few
years have led to general downward revisions to growth. Factor in a credit
crunch and volatility in equity markets and everything points to lower interest
rates. The confident predictions of 6% by the end of 2007 have long gone, to be
replaced by 5% by the end of 2008. This would ease the debt pressures and give a
bit of a boost to spending.
But what happens if oil (and now food) prices take the CPI back into danger
territory? Will the MPC be more concerned about the risks of rising prices or
slowing growth? This is an uncomfortable choice and when we faced it in the
1970s (albeit with smaller numbers), it was called stagflation. Perhaps 6% might
still be on the agenda in 12 months time.