By John Kemp
LONDON Feb 23 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
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
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.