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Macro View: Continued fall in oil prices masks malign forces

THE sharp drop in oil prices, with Brent crude falling by more than 55% since June 2014, is a global event with far-reaching economic and strategic consequences. While companies and countries that depend heavily on oil revenues will be worse off, the world as a whole will benefit.

Cheaper oil is equivalent to a tax cut for oil consumers. Since the propensity to spend of net importers such China, Europe and Japan is higher than that of many oil exporters, mainly those in the Gulf, the world economy will see a net rise in demand. But the positive impact of falling oil prices masks conflicting forces and many of these are not benign.

To the extent that plummeting oil prices reflect increased supply, primarily the surge in US shale oil production, prospects will improve and recurring hikes in oil prices will no longer be one of the factors limiting global growth. But if the fall in oil prices is due to a persistent weakness in global demand, the implications are much more worrying.

In such circumstances, cheap oil may alleviate pressures but cannot overcome threats of stagnation. The gloom in the stock markets in the first few days of 2015 highlights deep concerns, which are magnified by renewed fears over Greece and eurozone deflation.

US shale oil, which has altered the balance of power in the energy market and has reduced dependence on OPEC, will have beneficial effects on Europe, Japan and other importers. The US will also be a beneficiary, as it is still a huge net importer, even though it is now the biggest oil producer.

The countries facing the most immediate pain are Russia, Iran and Venezuela. Being heavily dependent on oil, they are finding it difficult to balance their budgets and their currencies are falling. In the short term, prices may continue to fall. Brent crude, plunged from $115(£76)/barrel in June 2014 to $50/barrel early in 2015, could fall towards $40/barrel in the next few months. Tensions within OPEC, and Saudi Arabia’s refusal so far to restrict output, could accentuate the fall. The Saudis are the strongest OPEC member, and they prefer to increase market share in spite of the short-term pain the lower price is causing. Saudi extraction costs are lower than in many other countries, notably the US, and their hope is that a prolonged period of cheap crude will force shale oil producers to cut output. This is not yet happening; but if lower prices force cutbacks in shale oil, the result could be instability, followed by a new cycle of higher prices.

US growth remains consistently stronger than in the eurozone and Japan. Revised estimates show GDP grew by an annualised rate of 5% in Q3 of 2014, the fastest pace since Q3 of 2003 and much stronger than the 4.3% pace the markets expected. Consumer spending and business investment are key contributors, and the upturn is underpinned by an improving jobs market. Our US GDP growth forecasts are being upgraded, to 2.4% in 2014 and 3% in 2015. The US economy created 321,000 jobs in November 2014, far more than the 230,000 most analysts were predicting. The jobless rate, which is derived from a different survey, was unchanged at 5.8%, the lowest level since 2008.

Rising home prices are still making a modest contribution, though the housing market is slowing. In October 2014, house prices have risen by 4.6% from their level a year earlier, less than half the year-on-year increase of 10.9% recorded in October 2013.

The signs of strengthening growth are making it difficult for the Fed to formulate its strategy. Differences among officials over the timing of the first increase in official rates have sharpened. In its recent minutes, the Fed’s language has become more hawkish and it is clear the US will tighten policy before other major economies. But the first increase in the funds rate is unlikely until Q2 2015 at the earliest. With annual US inflation at 1.3% in November 2014 and the eurozone and Japan afflicted by fears over deflation, most Fed policy makers will not rush to raise rates.

Dismal prospects
Eurozone prospects remain dismal, but there are signs the situation is stabilising. Growth expectations, after being lowered, are now being slightly upgraded due to lower oil prices. The December purchasing managers’ index shows an improvement over November, and indicates the economy will avoid recession, even though the pace of growth remains slow. Even so, our eurozone GDP growth forecasts are being raised marginally, to 0.8% in 2014 and 1.0% in 2015.

But sadly, this improvement is under threat of being nullified by a new political crisis in Greece. If the election brings to power a populist left-wing party (Syriza) pledged to renege on the country’s fiscal commitments, the eurozone’s future will be questioned. Rumours Germany will then be prepared to accept a Greek exit, though hotly denied, are unsettling the markets, pushing the euro to a nine-year low against the US dollar. These concerns, coupled with fears over deflation as December consumer prices recorded a 0.2% year-on-year fall, will intensify pressure on the ECB to launch a QE programme. Influential German officials still oppose such a move, but it seems more likely that the ECB will launch QE in the next few months.

The UK recovery is continuing at a satisfactory pace, and quarterly GDP growth in Q3 of 2014 was confirmed at 0.7%. But annual growth was revised down from 3% to 2.6%, as previous quarters were weaker than initially estimated. The UK is still growing more strongly than all the major eurozone members, including Germany. But the UK economy is facing major challenges that will take time to resolve, the foremost being the “twin deficits” – budget and external.

Eliminating the fiscal deficit is taking much longer than planned, and will require spending cuts until the end of the decade. Meanwhile, the current account deficit has risen to record levels that may endanger the UK’s credit rating. The general election in May is adding to the uncertainties facing UK businesses. With UK inflation expected to fall below 1% in the next few months, there is no case for an early increase in interest rates. While two members of the Monetary Policy Committee have voted in recent months for an immediate rise in rates, we expect the majority to wait until Q3 of 2015 at the earliest before considering any move.

David Kern of Kern Consulting is Chief Economist at the British Chambers of Commerce. He was formerly NatWest Group Chief Economist

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