From feast to famine
What happened to cheap oil? Brent prices have been rising steadily and are currently trading at $78 a barrel. This represents a 50% increase over the past 12 months and the highest price recorded since oil started to fall precipitously in late 2014. There are a number of explanations for this ramp up, mostly centred on concerns over oil supply. The US withdrawal from the Iran nuclear deal was the trigger for higher prices last week, raising uncertainty around Iranian crude exports. This adds to fears over Venezuelan production and broader geopolitical tensions in the Middle East. Shifts in oil prices, driven by supply shocks, have a number of tell-tale implications. Easiest to spot is the effect on inflation as higher oil prices feed directly and indirectly into consumer prices. Across the OECD, CPI was up 2.6% in six month annualised terms in Q1, led by an 8.2% rise in energy price growth. When exploring trends in household consumption in a recent edition of this publication, we noted that this inflation squeeze likely contributed to weak consumer spending at the start of the year. Of course, not everyone loses from higher prices, with producers/exporters feeling the benefit through stronger production and investment.
Oil supply concerns represent a sudden shift from the environment of abundant production and low prices between 2014 and mid-2016, when OPEC attempted to wrestle market share away from rapidly growing shale producers. With prices rising again, will shale oil be able to fill the supply gap? ECB research based on micro data from shale producers suggests that existing wells can produce up to 6 million barrels per day. Moreover, it estimates that at prevailing prices this could rise to almost 10 million barrels as new projects become profitable. The downside is that it will take until 2020 for these wells to come on line. Therefore, while shale continues to represent a structural change in oil supply dynamics, this is still not elastic enough to prevent short-term tightness. The oil futures forward curve, which we and most central banks condition our forecasts on, shows that the markets expect the recent spike to prove temporary, with Brent to slowly decline from current levels. However, should prices continue to spike, then this oil supply shock risks throwing a spanner in the works of the synchronised global upswing.
Give and take
US consumers are already feeling the effects of higher oil prices. Perhaps the most commonly used anecdote is how much it costs to fill your car. Gas prices have jumped 28 cents a gallon since the turn of the year to $2.75 – an 11% increase over this short period. While gasoline consumption has been declining steadily on the back of fuel efficiency gains and shorter average distances driven, this still equates to an average increase in household bills of close to $300 a year. However, oil prices do not only affect consumers through gas prices. Indeed, the broader energy component accounts for around 8% of the CPI basket, and alone is contributing 0.5 percentage points to headline inflation at present (see Chart 2). Finally, higher oil prices feed indirectly into consumer prices via higher production costs for non-energy goods. The IMF has estimated that this channel contributes around a third of the overall shock from higher oil prices to domestic inflation. The upshot is that further oil price driven increases in annual US inflation rates are likely on the way over coming months, before gradually fading over the second half of the year.
Typically this jump in inflation would serve to weigh on growth, by dampening household incomes and corporate margins. However, changes in the US energy sector over recent years will push in the other direction. US crude oil production surpassed 10 million barrels per day late last year, a benchmark not hit since 1970. This makes the US the third largest oil producer in the world, helped by transformative technological breakthroughs in the shale sector. The upshot is that higher oil prices will boost activity, employment and investment in this sector and related industries. Indeed, we have already seen the Baker Hughes rig count start to rise, albeit to levels still around half of the 2014 peak. Changes in the energy sector also affect trade. The US petroleum deficit has shrunk notably over recent years, helping partly mask an alarming rise in the non-petroleum gap (see Chart 3). Higher oil prices will therefore have a smaller effect on the overall deficit. So what is the net effect? Research by Brookings found that the boost to incomes/margins from low inflation was offset by sharp declines in oil investment during the 2014 and 2015 fall in oil prices. However, this time may be different. Tighter credit conditions in the sector, scrapped drilling and fracking equipment, uncertainty over longer term-oil prices and skills shortages could all dampen the boost from oil investment. Overall, rising oil prices should still provide a drag on growth, albeit a much smaller one than we might have expected a decade ago.
The Fed will be watching this trade off closely. With both headline CPI and PCE measures of inflation above target, and core indicators very close to this goal, it is increasingly confident that the drags seen over the course of 2017 were temporary in nature. If we are right that inflation pushes higher in coming months then this may add to calls for a faster withdrawal of policy accommodation from more hawkish quarters of the Federal Open Market Committee. However, the committee has been at pains to signal that its inflation target is symmetric, meaning that it will not react disproportionately to temporary overshoots. Indeed, the Fed has up until now been relatively happy to look through the effects of rising oil prices, keeping its focus firmly on domestic fundamentals. This approach is expected to continue, barring any sharp shocks.
The Bank of England voted 7-2 to leave Bank rate on hold at 0.5% last week. This is a significant turnaround from where we were a month or so ago, when a hike was nearly 100% priced. However, a run of mixed data and a pointed intervention by Governor Carney caused the market to largely rule out a move. The Bank essentially endorsed the existing market pricing of three hikes over three years, projecting inflation back to 2% two-to-three years ahead on the basis of this profile. With uncertainty currently elevated, the Bank seems not only data dependent, but also highly data sensitive, and the majority of the Monetary Policy Committee (MPC) wants to wait until it becomes clear that Q1's soft patch was genuinely only temporary before raising rates further. Without strong conviction in the outlook, the Bank is less inclined to simply dismiss and look through temporary deviations from its forecasts.
GDP growth for this year was revised down from 1.8% to 1.4%, reflecting the weak start to the year. However, the MPC expects Q1 growth to be revised up to 0.3% in time, as it believes survey data is consistent with a higher rate of growth than the 0.1% estimate from the ONS. Indeed, the Bank is convinced that the ONS systematically understates GDP growth in its initial estimates. The fundamentals that underpin the Bank's forecasts were largely unchanged. It sees: unemployment already slightly below its 4.25% estimate of the natural rate of unemployment; potential growth of only 1.5%; and "very limited" existing spare capacity. With productivity growth so slow, even quite modest wage growth can represent an increase in unit labour costs and upward pressure on inflation. Productivity growth has actually recently shown some signs of coming back to life, posting two strong quarters of growth. If this trend continues, the Bank will need to revisit its fairly pessimistic view of the supply side (see Chart 4). For now, the Bank's forecast of the evolving supply and demand balance necessitates a "gradual and limited" hiking cycle.
The most significant forecast change was on the pass-through of sterling depreciation into inflation (see chart 5). The Bank is now forecasting slightly less pass-through, reflected in a slightly lower inflation profile with price growth coming back to target sooner than previously expected. The declining impact of sterling's depreciation on inflation means the Bank no longer believes it faces the same pressing trade-off between stabilising growth and inflation. It is now setting policy to bring inflation back to target over the "conventional horizon" of two years, rather than the three years it had been working to previously. Overall, we maintain our forecast for a hike in August, followed by two more hikes next year. This is predicated on our expectation that Q1 weakness in the UK (and the Eurozone) will be largely temporary, and the recovery in activity will be sufficient by August to give the Bank comfort to hike. However, we note that the risks to this forecast are now skewed to the downside, with the possibility that households will use the opportunity provided by the end of the real wage squeeze to start to boost savings. The Bank has shown itself particularly sensitive to incoming information, which could lead to the perception of confused signalling and communication in the run-up to August.
A temporary boost
Eurozone headline inflation stood at just 1.2% in April. That is some way below the European Central Bank’s (ECB) inflation target of “below, but close to, 2%” (See Chart 6). Moreover, underlying core inflation, which strips out energy, food, and other volatile components, was just 0.7%. Some of this weakness is temporary: the early Easter this year pushed up package holiday prices in March, rather than in April as last year, weighing on core services inflation. A bit of a bounce back in the next reading is likely. But it is clear that the Eurozone is not yet experiencing the sustained adjustment in the path of inflation towards target that the ECB has made a precondition for removing its current monetary policy accommodation.
The surge in oil prices over the past year or so is about to provide a significant but temporary boost to headline inflation. Oil prices denominated in euros have risen around 30% in year-on-year terms. If the oil forward curve is right, that could increase to 50% year-on-year over the next few months. Euro-denominated oil prices tend to have a close relationship with the energy component of Eurozone inflation, which is likely to start rising fairly rapidly over the summer (See Chart 7). Energy inflation accounts for about 10% of the overall inflation basket, and could raise headline inflation by as much as 60 basis points between now and August. But again, if the forward curve is right, that boost will fade and eventually turn into a small drag on headline inflation during 2019. Moreover, although higher oil prices mechanically boost headline inflation, given that the Eurozone is a large net oil importer, they also represent a drag on overall economic activity, which could modestly eat into real consumer spending and overall GDP growth.
More fundamentally, Eurozone core inflation is responding only very gradually to the steady erosion of spare capacity and an ever lower unemployment rate. Eurozone unemployment has come down from a peak above 12% in 2013 to 8.5% now, but with only a very small upward move in measures of wage growth and core inflation over that time. In other words, the Phillips curve relationship between measures of spare capacity and wage and price inflation is fairly flat. Structural flattening of the Phillips curve has been a global phenomenon, driven by a combination of globalisation, the reduced bargaining power of labour, and stubbornly low inflation expectations. Admittedly, at a Eurozone member state level, there are growing labour shortages in certain economies. In Germany, the unemployment rate has reached a 36-year low of 5.3%, firms are complaining of labour shortages, and there have been some high profile wage increases, most recently for workers in the IG Bau construction workers union. Germany has historically had among the flattest Phillips curves of Eurozone member states, although recent wage agreements among the unionised labour force may point to some re-steepening of the Phillips curve relationship. Our own modelling work suggests that, even with a steady decline in the Eurozone-wide unemployment rate over the next few years, if the structural flattening of the Phillips curve is sustained then it will be difficult to generate inflation consistent with the ECB’s target once the short-term boost from higher oil prices fades.
Ready for lift-off?
Rising oil prices are normally bad news for Developed Asia given its dependence on oil imports (see Chart 8). Rather unusually, the recent oil price rise has occurred in conjunction with a rising dollar – implying that the effects should be amplified outside the US dollar zone. So how will the rise in energy prices effect the region’s economies and what are the implications for inflation and policy settings?
Let us start by looking at the corporate sector. Though less exposed to upstream components, a number of developed Asian economies are surprisingly integrated into the global energy supply chain. South Korea is a noticeable beneficiary of energy capex, particularly in the Middle East, through both shipbuilding and construction services. In Singapore, higher oil prices may ease the plight of the marine and offshore engineering sectors. Offsetting the positive for oil-related exports are concerns about margins more generally. An erosion of pricing power has limited firms’ ability to pass on costs and has served to subdue wage growth in the region. If corporates are similarly forced to wear energy costs the implications for margins could be material. We do think that firms are more insulated to energy shocks than in the past due to a reduction in oil dependency and the level of energy intensity. Japan has a clear advantage here, while Taiwan remains relatively oil hungry (see Chart 9). The story for the household sector is clear cut. A combination of weak real income growth, elevated savings rates and ageing demographics has meant that consumption has persistently disappointed. The effects of policies designed to promote consumption-led growth in the region, such as the hikes in minimum wages and expansion of social security provision, are still nascent, making an energy-led real income squeeze untimely. So far consumer confidence has held up ok but developments here are worth closely monitoring.
Turning to the inflation effects, let us first try to quantify the impact before considering the implications for policy. Judging by the weightings of energy in CPI, Japan is likely to see the biggest impact (7.8%) followed by a more modest impact for Taiwan (4.3%) and Korea (4.2%) and finally Hong Kong (2.4%). It is worth tackling Japan’s case in some detail. Based on recent history, a $10 per barrel rise in oil will push up CPI by some 0.3%. Consequently, we expect inflation to accelerate later this year, having stalled around 1%. However, we would be cautious about claims this provides evidence inflation is on its way to the 2% target. Core-core inflation is stuck at 0.3% y/y, while the Bank’s preferred underlying measure is just 0.5% y/y. Furthermore, the last temporary spike in inflation, driven largely by 2015 yen effects, backfired spectacularly as households retrenched due to the real income squeeze. The hope is the economy is better placed to allow wages to adjust accordingly. However, delays to workstyle reform legislation have reduced conviction here. Consequently, we suspect that any move to adjust policy due to a temporary increase in energy prices is likely to be viewed as a capitulation, pushing the yen significantly higher. In contrast, core inflation measures elsewhere in the region are all firmly ensconced above 1%, providing a better platform for rates lift off than in Japan. Indeed, if growth effects are modest the pick-up in headline inflation may provide a useful excuse to begin to normalise rates.
Another week another crisis
How might Trump’s decision to pull the US out of the Iran nuclear deal (JCPOA) impact oil prices, and if prices go higher how could emerging markets (EM) be impacted? In terms of Iranian crude supply, it’s unclear how much crude exports will be reduced by unilateral US sanctions. Pre-JCPOA sanctions removed approximately 1 -1.5 million barrels from the daily market (see Chart 10), but at the time sanctions were a unanimously agreed multilateral effort (see chart 11). In current conditions, countries such as China might not comply or will circumvent sanctions, and other countries will vigorously seek exemptions. Without global cooperation (which is unlikely) the return of US sanctions will be less harmful than the sanctions regime that existed prior to the agreement being struck. It took the combined efforts of Congress and two US presidents over nearly a decade to cripple Iran’s economy. Rebuilding economic pressure will now be an even greater challenge, given international opposition to the US withdrawal and scant international support for renewed sanctions. With an unclear compliance and enforcement outlook, most estimates show that the decline in Iranian crude exports will be modest.
While the range of political outcomes is wide and there are innumerable uncertainties around the Iranian response and Trump administration policies, we think four broad factors will be important to determine how oil prices are impacted. First, the response from US shale − US crude output continues to hit new highs as rig counts continue to rise, although this may be a slow process. If Iranian exports decline modestly (200-500,000 barrels per day), US production could potentially offset the loss. Second, the Saudi/OPEC/Russia reaction -- Saudi Arabia could increase production to offset without impacting prices. This could be done both to increase market share but also due to potential pressure from the Trump administration to prevent prices from rising. Third, the China response − China is Iran’s largest customer and its refineries are particularly geared towards Iran’s heavy crude. China had exemptions during the pre-JCPOA sanctions that allowed it to continue importing Iranian crude albeit at slightly lower levels. This time around, it is less likely to comply and may continue importing higher levels of Iranian crude, especially now that it will probably receive discounted prices. Fourth, risk premium − the impact on oil prices may be less a factor of lower Iranian production and more a factor of higher risk premium as stability in the region is further undermined. Iran’s response is an open question, and the Middle East could be further destabilised. Oil markets were positioned very long prior to the announcement, suggesting the decision was already priced in; nonetheless, higher volatility will likely result.
If prices do rise on the back of reduced Iranian supply, greater economic differentiation is expected across EM. The macro impact of higher oil prices differs depending on the supply and/or demand driver. A demand-driven rise in oil prices can be cushioned by a strong pick up in exports. On the other hand, a supply-side driven rise in oil prices is more damaging to oil importers because, in the absence of a strong pick up in exports, the higher import cost of oil would worsen current accounts, compress margins and raise inflation. In this situation, Turkey, India, and the Philippines look exposed.