COLUMN-European economies suffer regional oil shock: Kemp
By John Kemp
LONDON Feb 23 (Reuters) - The combination of surging oil prices and weak currencies is subjecting Europe's economies to a classic oil shock, which will add to the region's economic woes in 2012.
So far, strong currencies have blunted the impact on the United States, China and Japan. But the magnitude of oil-price rises, coupled with an expected recession in Europe, will probably cause growth to slow in these economies as well by mid-year.
NET PRICE RISES
Not all price changes have the same economic impact. Nonetheless, "the correlation between oil shocks and economic recessions appears to be too strong to be just a coincidence," University of California Professor James Hamilton wrote in a 2010 paper on "Historical oil shocks".
Surveying the experience of the United States, Hamilton found, "All but one of the 11 post-war recessions were associated with an increase in the price of oil, the single exception being the recession of 1960. Likewise, all but one of ... 12 oil price episodes ... were accompanied by U.S. recessions, the single exception being the 2003 oil price increase associated with the Venezuelan unrest and second Persian Gulf War."
Hamilton found price changes have a non-linear impact on GDP. "Oil price increases affect the economy, whereas decreases do not, and increases that come after a long period of stable prices have a bigger effect than those that simply correct previous decreases," he wrote in a paper entitled "What is an oil price shock?" published in 2000 and updated since then.
In other words, price rises are more likely to affect the economy if they set a new high beyond the recent experience of consumers and firms, rather than just reversing earlier declines. New highs maximise pain on household and business budgets and create damaging uncertainty about whether prices will rise even more in future.
To capture this look-back effect, Hamilton argues the impact can best be understood by looking at the "net oil price increase". The net increase distinguishes between rises that establish new highs compared with some previous period and those that simply reverse declines. The bigger the net rise, the bigger the impact on economic output.
Obviously, it depends on what is meant by recent experience. Hamilton used the net increase compared with the maximum price over the previous 12 months, though others have used a longer timeframe of up to three years.
Chart 1 shows net price increases over the previous 12 months for U.S. and Brent crude (using front-month futures prices), as well as Brent prices expressed in euros, sterling, yen and yuan, and U.S. retail gasoline prices.
Using this measure, European economies paying for Brent in euros began suffering an oil shock in January, and Britain will formally start to experience an oil shock in the next few days, if the current Brent price and sterling/dollar exchange rate are maintained.
Countries with stronger currencies have been somewhat insulated and are still some way from shock levels. Brent would need to rise a further 4 percent before the United States starts to experience a "Hamilton" shock, while U.S. gasoline prices are around 9 percent away from shock level. For China, Brent prices are 7.4 percent below shock levels, while in Japan the difference is 10 percent.
Even in Europe, net increases are so far small, limiting the impact. The net price increase in euro-denominated Brent so far in February compared with the previous 12 months is just 4 percent. Last year, the net increase in euro-denominated Brent was 10 percent in March 2011, resulting in a much bigger hit to consumer and business costs and confidence (Chart 2).
TAXES AND PRICES
End-customers are more concerned about the retail price of refined products than crude oil. Final product prices are influenced by refining margins and especially taxes.
Excise and sales taxes accounted for two-thirds of the price of final fuels in Europe in 2010, according to OPEC, compared with 50 percent in Japan and 16 percent in the United States. Rising crude prices therefore have a much smaller proportionate impact on final motoring and heating costs in the EU than Japan or the United States.
The psychological impact of price rises may also have been blunted by Europe's long-standing strategy of raising fuel duties to raise revenue and encourage take up of more fuel-efficient vehicles, which has left many motorists sullenly resigned to annual price increases.
The scale and speed of recent price gains is nonetheless likely to cause "sticker shock" at a time when many European households and businesses are struggling with sluggish growth and unemployment, adding to the region's economic problems.
Assessing the precise economic impact of an increase in oil prices remains beyond even the most advanced economic models used by the Fed and other central banks. Hamilton has explored how "memories" of past oil prices affect the response of businesses and consumers to a price rise. But other factors such as central bank responses and the general state of confidence in the economy also play a key role.
So far, the Hamilton net price rise has been small for customers paying in sterling and euros - and more marginal once the focus switches from crude to refined products such as gasoline and diesel. Customers in the United States, China and Japan have been somewhat sheltered from rising prices by the relative strengthening of their currencies.
But it would be unwise to dismiss the economic and psychological impact of recent price gains. Hamilton net increases assume a reversal of earlier price declines has little or no effect on the economy, and only net rises have a significant impact on economic performance.
Such an abrupt "threshold effect" is a simplification. In reality the impact is likely to build gradually. Price gains probably start sapping confidence even before they breach recent peaks. Even in the United States, where crude and product prices are below the 12-month maximum, rising prices have probably started to have a negative impact.
Recent price rises have also occurred very quickly (less than two months ago most analysts were predicting oil prices would be stable in 2012). The rate of increase is accelerating. And there is considerable uncertainty about how much further prices might increase if tensions with Iran continue to worsen. Prices are also rising from a very baseline, and household budgets are already stretched.
These are precisely the conditions calculated to maximise uncertainty among consumers and businesses and encourage them to postpone purchases of big-ticket items, causing growth to slow.
Policymakers and oil analysts must therefore assume that if prices are sustained at current levels, or increase, there will be a significant blow to the economy. While it may be felt first in the EU, it is unlikely the United States and China will escape the effect of a similar shock on their own economies.
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