The recent developments in the Middle East and North Africa have been the focus of attention for policymakers as the implications of escalating unrest are significantly problematic for the global economy. The recent upward pressure on oil prices has been a reflection of market expectations rather than actual shortages in supply but there are fears that the recent surge in oil prices could persist if the political tensions in the region do not improve.
The effects of a prolonged spike in oil prices would spread throughout the global economy and serve as a catalyst for widespread inflation.
- Surging oil prices reduce the amount of disposable income that consumers have available to spend in the economy ultimately weakening aggregate demand (sometimes referred to as the “crowding out” effect)
While weaker aggregate demand is certainly not inflationary, upward pressure on prices will be the result of a number of factors.
- Workers could demand higher wages to offset the greater share of their income being dedicated to fuel expenses. Although high unemployment limits the probability of this occurring.
- Businesses facing a combination of increasing fuel and employment costs are likely to pass these costs on to consumers via higher prices.
Accompanying these steps is likely to be an increase in inflation expectations throughout the economy at which point these expectations could become self-fulfilling. Regardless of the specific contributing factors, history demonstrates clearly the relationship between the oil market and the US economy.
From FT Alphaville:
At this time, there is little doubt that a short-term oil crisis could be managed effectively but the prospect of a lengthy crisis puts the global economy in a precarious position. According to an IMF official:
The world economy can withstand the surge in oil prices sparked by unrest in the Middle East and North Africa so long as the increase proves short-lived, said the International Monetary Fund’s No. 2 official, echoing Deutsche Bank AG and Bank of America Merrill Lynch.
While an extended $10 advance in oil cuts 0.5 percentage point off U.S. growth over two years, the world’s biggest economy will expand 3.8 percent this year, almost a percentage point more than in 2010, according to Deutsche Bank.
“The global recovery now faces a serious threat from a sustained oil-price spike,” said David Hufton, London-based managing director at PVM Oil Associates Ltd.
About $10 of the recent increase in the oil price relates to tension in the Middle East and Africa, with the remainder a reflection of the strengthening global economy, said Julian Jessop, chief international economist at Capital Economics Ltd. in London.
“The old rule of thumb was that a $10 increase reduces global growth by half a percent, but if that still held then the world would now be in a deep recession,” said Jessop, a former U.K. Treasury official.
In response to these ongoing developments, officials from the Federal Reserve made several comments to shore up confidence in the ability of policymakers to address any challenges associated with tensions in the Middle East and North Africa.
(Reuters) The Federal Reserve would react to higher oil prices only if the increases spilled over into broader areas, officials of the U.S. central bank said on Friday, with one policy maker calling the risks “manageable.
The president of the Richmond Federal Reserve Bank, Jeffrey Lacker, took a calm view of the potential threats to the U.S. economy from the higher oil prices, though he said they could prove nettlesome if they jump much more or create an inflationary psychology.
“I think the oil price rises we’ve seen so far don’t pose a risk to the recovery,” he told reporters after a speech on regulation.
“Oil price changes could have the potential, if they were very large, for slowing the recovery, but we have a lot of experience and a lot of data on past instances, and I think it’s a manageable risk,” he said at a conference organized by the University of Chicago’s Booth School of Business.
Janet Yellen, the Fed’s vice chair, said U.S. central bank officials would react if inflation expectations or underlying inflation show persistent gains and began to be reflected in other prices.
“Any increase that would seem to be sustained in inflation expectations, or in core inflation, that looked like it were getting passed through and it was sustained, would … demand a response,” said Yellen, who is viewed as among the strongest proponents of aggressive measures to support the economic recovery.
From FT Blog Gavyn Davies:
