Will the oil stabiliser prevent global recession?
July 8, 2012 12:42 pm
by Gavyn Davies
The past week has seen the publication of generally weak economic data which suggest that the global GDP growth rate in 2012 Q2 will be the lowest recorded since the “recovery” began three years ago. Many of these data were analysed here on Friday. Since then, the US jobs data for June were anaemic at best, indicating that American business spending is now slowing in both capital expenditure and job creation.
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Furthermore, the eurozone crisis has moved in the wrong direction in the past week. The ECB cut interest rates on Thursday, but Mario Draghi poured cold water over the idea that the central bank balance sheet could be used to purchase significant quantities of Italian and Spanish debt, or to leverage the inadequate balance sheet of the ESM. Even more worrying, the Wall Street Journal reports that last week’s summit did not, after all, agree that bank capital injections should by-pass the balance sheets of sovereign governments. Instead, governments will reportedly be expected to guarantee these capital injections, which greatly waters down the force of the statement made after the summit.
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European activity data stabilised somewhat in June, but the absence of a genuine resolution to the crisis will hang over the region’s economies for many more months. The key near term question for the global economy is whether the serious effects of the eurozone shock can be mitigated by the renewed operation of the oil stabiliser, which has been growing in importance in the last few years. Here lies the silver lining, if there is one.
The eurozone crisis has reduced the growth rate of the world’s second largest economy from about +2 per cent to about -1 per cent in the past 12-18 months. Using the normal elasticities between eurozone GDP and trade flows, this 3 per cent swing implies that the growth in eurozone imports from the rest of the world is about 10 per cent lower than it otherwise would have been. The consequent direct effect on the GDP growth rate of other regions is around -0.5 per cent. Multiplier effects will make this impact larger, as will financial spill-overs from the reduction in the balance sheets of eurozone banks in the rest of the world.
Overall, the eurozone shock has probably slowed the growth rate in the rest of the world economy by about 1 percentage point since the beginning of 2011, which (in broad terms) is about half of the total slowdown which has occurred over this period. As discussed here, the rest is due to a combination of tighter fiscal policy, higher oil prices and adverse confidence effects on business spending. Easier monetary policy is helping, but most of these other effects appear destined to remain adverse for the foreseeable future.
The important exception, however, is the recent drop in oil prices. If maintained, this will have a powerful stimulatory effect on the developed economies in the second half of 2012.
The behaviour of the Brent oil price ($ per barrel), compared to its one year moving average, is shown here:
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In recent weeks, Brent and other oil prices have been somewhat volatile, but have been hovering around $90-100/barrel, which is about 25% lower than the peaks which were seen earlier this year. In the bottom half of the chart, I show the ratio of the oil price to the one year moving average, which in the past has been a useful indicator of the contractionary or stimulatory effect of oil prices on short term economic activity.
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In some ways, this can be treated as equivalent to an “interest rate” which tightens or eases demand conditions in the world economy. I call this the “oil price regulator”.
The precise impact of changes in oil prices on US and global GDP has been much studied by economists in the past decade, and it remains a subject of some dispute. James Hamilton published a highly influential paper in 2003 which suggested that the impact of oil prices on US activity was non linear. Large increases in the oil price relative to previous highs caused a great deal of economic dislocation with significant recessionary results, but declines in the oil price had little or no effect in boosting GDP.
If Hamilton’s conclusion is still valid, then the recent drop in the price of oil would not be a silver lining at all, since it would be irrelevant for world activity.
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However, recent work by Lutz Kilian and Robert Vigfusson casts doubt on the asymmetric nature of oil shocks, arguing that the 3-year change in oil prices have important effects on GDP in both upward and downward directions. Furthermore, a paper published last week by Kamakshya Trivedi and Stacy Carlson of Goldman Sachs shows that the impact of oil prices on GDP not only works in both directions, but has also increased in size in recent years.
The second graph shows the oil price regulator (plotted inversely, and shifted 6 months forward), compared to the global manufacturing sector PMI, which is used to represent the global economic cycle...
It is clear that variations in the oil price have been somewhat correlated with activity six months later, though the relationship is far from perfect. The Goldman economists estimate that a 20 per cent change in oil prices has impacted the global PMI level by about 5 index points in the period since 2007. This operates with a time lag of a few months.
If these results are correct, and all else being equal, then the recent drop in oil prices might be expected to take the global PMI back about 53-54 before the year end, which is consistent with positive, but below trend, global GDP growth. A similar conclusion is reached from the work of Bruce Kasman and others at J.P. Morgan, who suggest that the recent drop in oil prices will boost annualised global GDP growth by 0.8 per cent in the second half of 2012, taking it back above 2 per cent.
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The conclusion of all this is that the oil price regulator may be able to offset the eurozone shock over the balance of this year, assuming oil prices do not rebound. Global GDP growth would remain unsatisfactorily below trend, but would not fall into recession.
The eurozone crisis has reduced the growth rate of the world’s second largest economy from about +2 per cent to about -1 per cent in the past 12-18 months. Using the normal elasticities between eurozone GDP and trade flows, this 3 per cent swing implies that the growth in eurozone imports from the rest of the world is about 10 per cent lower than it otherwise would have been. The consequent direct effect on the GDP growth rate of other regions is around -0.5 per cent. Multiplier effects will make this impact larger, as will financial spill-overs from the reduction in the balance sheets of eurozone banks in the rest of the world.
Overall, the eurozone shock has probably slowed the growth rate in the rest of the world economy by about 1 percentage point since the beginning of 2011, which (in broad terms) is about half of the total slowdown which has occurred over this period. As discussed here, the rest is due to a combination of tighter fiscal policy, higher oil prices and adverse confidence effects on business spending. Easier monetary policy is helping, but most of these other effects appear destined to remain adverse for the foreseeable future.
The important exception, however, is the recent drop in oil prices. If maintained, this will have a powerful stimulatory effect on the developed economies in the second half of 2012.
The behaviour of the Brent oil price ($ per barrel), compared to its one year moving average, is shown here:
.
In recent weeks, Brent and other oil prices have been somewhat volatile, but have been hovering around $90-100/barrel, which is about 25% lower than the peaks which were seen earlier this year. In the bottom half of the chart, I show the ratio of the oil price to the one year moving average, which in the past has been a useful indicator of the contractionary or stimulatory effect of oil prices on short term economic activity.
.
In some ways, this can be treated as equivalent to an “interest rate” which tightens or eases demand conditions in the world economy. I call this the “oil price regulator”.
The precise impact of changes in oil prices on US and global GDP has been much studied by economists in the past decade, and it remains a subject of some dispute. James Hamilton published a highly influential paper in 2003 which suggested that the impact of oil prices on US activity was non linear. Large increases in the oil price relative to previous highs caused a great deal of economic dislocation with significant recessionary results, but declines in the oil price had little or no effect in boosting GDP.
If Hamilton’s conclusion is still valid, then the recent drop in the price of oil would not be a silver lining at all, since it would be irrelevant for world activity.
.
However, recent work by Lutz Kilian and Robert Vigfusson casts doubt on the asymmetric nature of oil shocks, arguing that the 3-year change in oil prices have important effects on GDP in both upward and downward directions. Furthermore, a paper published last week by Kamakshya Trivedi and Stacy Carlson of Goldman Sachs shows that the impact of oil prices on GDP not only works in both directions, but has also increased in size in recent years.
The second graph shows the oil price regulator (plotted inversely, and shifted 6 months forward), compared to the global manufacturing sector PMI, which is used to represent the global economic cycle...
It is clear that variations in the oil price have been somewhat correlated with activity six months later, though the relationship is far from perfect. The Goldman economists estimate that a 20 per cent change in oil prices has impacted the global PMI level by about 5 index points in the period since 2007. This operates with a time lag of a few months.
If these results are correct, and all else being equal, then the recent drop in oil prices might be expected to take the global PMI back about 53-54 before the year end, which is consistent with positive, but below trend, global GDP growth. A similar conclusion is reached from the work of Bruce Kasman and others at J.P. Morgan, who suggest that the recent drop in oil prices will boost annualised global GDP growth by 0.8 per cent in the second half of 2012, taking it back above 2 per cent.
.
The conclusion of all this is that the oil price regulator may be able to offset the eurozone shock over the balance of this year, assuming oil prices do not rebound. Global GDP growth would remain unsatisfactorily below trend, but would not fall into recession.
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