ECB puts oil hit to potential GDP at less than 1% over four years

FRANKFURT, Aug 1 (Reuters) - A permanent surge in oil prices will reduce the euro zone's potential output by less than 1% over four years, a small hit that could be further reduced by the green transition, the European Central Bank said on Monday.

Economic theory suggests that permanently higher oil prices should reduce productivity and the economy's ability to grow, thereby creating the conditions for higher inflation.

But empirical research on the 1970s oil shock shows that economies can adapt over time, for example by reducing their reliance on fossil fuel.

Using its own forecasting model, the ECB found that an increase of 1% in oil prices would reduce the euro area's growth potential by around -0.02% in the medium term.

Assuming a 40% rise in oil prices in the next four years compared to 2017-20, the ECB concluded that potential output in the euro area would be cut by just 0.8% over that period.

"This constitutes a somewhat limited shock, which should be seen in the context of the cumulative increase in potential output, estimated by the European Commission to hover at around 5.2% for the next four years," economists Julien Le Roux, Bela Szörfi and Marco Weißler wrote in an article.

This is based on the oil market prices used in the ECB's June economic forecasts, which put a barrel of Brent crude at $105.8 in 2022 before it declines to $84.3 by 2024.

The ECB added its own reaction to excessive inflation, which saw it raise interest rates last month and guide for more hikes ahead, can further dampen the hit to potential growth by stabilising expectations.

In addition, a more flexible economy compared to the last oil shock can speed up technological change.

"In particular, for transportation and household energy consumption, viable green alternatives exist that are far less dependent on oil," the ECB said.

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