Lower oil prices are not a good thing for Vladimir Putin, Russia’s president: that much is clear. But what about for everyone else? The sharp fall in crude over the past three months has produced an unusual amount of concern that, with inflation already dangerously low across much of the developed world, cheaper oil will worsen the problem. Such fears are misplaced. To think that lower oil prices are a net negative for the world economy, and particularly for the advanced economies, is to misunderstand the problem with deflation and the cures for it. A falling overall price level, by and of itself, is not necessarily a bad thing. China periodically slipped into deflation from the late 1990s onwards as it embarked on an extraordinary period of expansion. But with economic growth at the time at or near double-digit rates, that reflected rapid productivity growth rather than excess supply. Any slowdown in demand could easily be met by reducing interest rates. The same is not true today for the advanced economies, particularly those within the eurozone. There, with demand too weak to match productive capacity and interest rates at or near zero, a sustained fall in the price level means that real interest rates rise. Higher real rates will encourage households further to postpone consumption and create a vicious circle of slow growth and excess capacity. Yet while lower oil prices will have a one-off arithmetic effect on the price level and hence reduce inflation, that should boost growth rather than retarding it. Lower oil prices may hurt capital-intensive extractive industries in the medium term, but they benefit households almost immediately through cheaper petrol and other fuels. An unexpected fall in the general price level raises real incomes. This is particularly welcome in the UK, where real median household incomes last year were six per cent lower than before the global financial crisis, despite a relatively healthy economic recovery. True, policy makers must be careful that a drop in the price level does not lead to falling expectations of inflation. But the answer to that is clear: keep monetary policy loose to boost demand. The European Central Bank and the Bank of Japan should continue expanding their programmes of asset purchases; the US Federal Reserve, which successfully took a similar route in the past, was right this week to say it would be “patient” in raising rates. There are competing explanations for why the fall in crude oil prices is happening. One is that new production, notably from the shale oil boom in the US, has increased global supply. Since oil is a relatively price-insensitive commodity, a small increase in supply can have a large impact on price. The fall became faster when, for whatever reason, Saudi Arabia persuaded Opec not to stand in the way of the falling price by cutting production. The less welcome explanation would be that the oil price fall is a consequence of external causes, namely a slowing world economy and weak demand from energy-intensive industrialising economies such as China. Happily, this seems unlikely to be all of the story, or even most of it: previous slowdowns in global growth have failed to produce the same reaction. But whatever is behind the falling cost of crude, the policy message is the same. At the current conjuncture, cheaper oil and loose monetary policy are complements, not substitutes. Central banks, particularly in the eurozone and Japan, have been struggling with preventing a sustained slide into deflation and economic stagnation. The fall in the oil price has given them a helping hand. They should take advantage.
Posted on: Tue, 23 Dec 2014 09:19:49 +0000
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