Sunday, August 14, 2005
The oil bubble will burst and interest rates fall
Posted by David Smith at 11:00 AM
Category: David Smith's other articles

The August sun has been beating down and the driving season is in full swing. And, oh yes, oil prices have been hitting record highs again, topping $65 a barrel.

The driving season, usually thought of as an American phenomenon, kicks off on the Memorial Day holiday weekend in late May and lasts until Labor Day in early September, when American motorists take to the highways in large numbers in search of rest and recreation. But it is also a European thing and, judging from my recent experiences on our crowded motorways, one we embrace enthusiastically here, even with petrol at 90p a litre.

Its significance is that it is associated with strong demand for oil, putting pressure on limited refining capacity. Everything, in fact, seems at present to be conspiring to push up oil prices. The driving season gives way to autumn and winter heating demand. If the weather is cold, oil demand increases; if global warming makes it hot, turn up the air conditioning.

Our appetite for oil continues unabated in spite of record prices. The eastward shift of the global economy and rising demand from China, with its 9.5% growth rate, is another seemingly permanent oil-price booster.

I will return to that in a moment. The big domestic economic news this month, however, has been generated by the Bank of England, first by cutting base rate from 4.75% to 4.5% on August 4.

Then last week, Mervyn King, the Bank’s governor, presented a new inflation forecast that offered little encouragement to the interest-rate doves. If the Bank’s forecast turns out to be correct, the monetary policy committee (MPC) will see little need to cut rates further.

There are some serious questions about that forecast. Growth over the past 12 months has been roughly half what the Bank expected last summer, yet it persists in predicting an early bounce-back in activity — from where is not entirely clear.

That was not the only curiosity. King has stressed that the Bank can achieve as much when not cutting rates as when it does, as long as people expect it to do so. The prospect of a succession of cuts could have cheered up households, encouraging more spending, so minimising the need for the MPC actually to make those cuts. Last week’s signals went against that spirit.

The Bank, it should be said, will always have a built-in bias towards saying that the present level of interest rates is right. Otherwise, why not change it immediately? To me, however, the big issue has been oil. Inflation, on the consumer-prices-index measure targeted by the Bank, stood at 2% in June, exactly in line with the target. A year earlier it was 1.6%, three months before that just 1.1%.

What has caused this rise? The Bank offers two competing views. One is that inflation has moved up because of pressure of demand. Firms, in other words, have got back some of their pricing power because of the strength of the economy. The other explanation is oil. In just over two years, oil prices have gone up from the mid-$20s to more than $60 a barrel. Petrol has risen from under 70p a litre to more than 90p. In this context, the surprise is not that inflation has risen but that it has risen so little. At a time when world oil prices have more than doubled, 2% inflation is a minor miracle.

And last week’s inflation report offered no definitive answer on this, something I would want as a priority if sitting on the MPC. Is it really plausible that the strength of demand has pushed up inflation? Not according to retailers, who say consumer demand has been weak.

So we should look to oil, both for its effect on inflation — “core” inflation, excluding energy and seasonal food, is running at only 1.5% — and its impact on growth. Part of the slowdown we have seen in Britain is due to the fact that high oil prices act as a tax on growth. The more people and businesses spend on energy, the less they have for other things.

Petrol prices have yet to reflect the impact of the latest rise in crude oil. Gas and electricity bills will rise further over the winter. As the Bank said, the current inflation rate of 2% is unlikely to represent the peak.

What happens then? While the futures market suggests that oil prices will head gently lower, many market participants are not so sure. Options markets suggest that the chances of a big rise in prices are greater than those of a big fall, with a 1-in-20 chance of prices being $100 a barrel or more in a year.

I’m not so sure. This is a nervy time for the global oil market, but the surge in prices has all the characteristics of a classic bubble. The International Energy Agency, in its latest oil-market report last week, said: “The unfolding statistical picture increasingly reveals that fear of the unknown and the consequent desire to make forward oil purchases is behind oil’s higher price path.”

It also warned that while the emphasis now was on the risks of higher prices, “as stocks and spare capacity increase, it must not be forgotten that the downside price risks will eventually emerge as well”. It predicts a rise in oil demand of 1.75m barrels a day in 2006, but a bigger increase in supply, split between Opec and non-Opec countries. Opec’s margin of spare capacity, currently a wafer-thin 1m barrels a day, will rise to 3m.

That does not mean oil prices are going to collapse. It does mean they are likely to return gradually to earth — which probably means a sustainable $40 a barrel — when geopolitical worries subside. That, in turn, will expose the fact that Britain’s higher inflation is largely an oil phenomenon, enabling the MPC to reduce rates further.

And what if oil prices were to hit $100 a barrel? The Bank would need to cut in those circumstances, too, to prevent an already slow-growing economy sliding into recession. Either way, despite the Bank’s cautious message last week, this month’s rate cut will not be the last.

PS: Robert Solow, the Nobel prize-winning American economist, once gave us his famous productivity paradox: “You see computers everywhere, except in the productivity statistics.” How come, in other words, a labour-saving device as significant as the personal computer hasn’t made us all much more productive?

One theory was that office workers spend the time freed up by their labour-saving PCs bidding for things they don’t need on Ebay, planning their holidays, or playing patience. Work, or something like it, expands to fill the time available, which we used to know as Parkinson’s law.

This theory suffered a blow when America experienced a computer- related (or at least an ICT — information and communications technologies-related) productivity boom, beginning in the 1990s. The question then became: Why isn’t it happening here?

According to the Bank of England, British workers have the same amount of computer capacity as American ones. But while American workers have been turning in improved performance, productivity here stays in the doldrums.

The solution to the puzzle, according to the Bank, could be that there have indeed been significant computer-related productivity gains in Britain. Heavy ICT-using sectors, such as business services, finance and distribution, have been responsible for two-thirds of the new investment in this area. And, sure enough, productivity has improved markedly, particularly in the past two to three years.

The trouble is this better performance has been offset by declining productivity elsewhere in the economy. The Bank cites the construction industry’s poor recent record. I am sure readers can think of others.

From The Sunday Times, August 14 2005

Comments

So the answer to everything is to cut Interest Rates ? Doesn't matter whether the oil price is up or down.

When Interest Rates are at already very low levels, this strategy has a law of diminishing returns.

Cutting rates further will be like putting your foot down on the accelerator without their hardly being any fuel left in the engine.

I find it amusing why there is still so much pressure on the BoE to keep reducing rates - if we can't get the economy moving on 4.5% then you have to look at other reasons why we're slowing down.

The "fuel" I was referring to is money, of which the British consumer has hardly any left of because their crippling mortgages, housing costs and other costs (which are conveniently ignored in CPI).

It looks to me like the "inflation" figure has been fiddled for years.

Plus there's the small matter of £1.1Trillion of a debt and housing bubble out there - an oil bubble as you suggest is small fry in comparison.

Posted by: Warwickshire Lad at August 14, 2005 09:41 AM

We just had a very fascinating discussion of whether Oil is or isn't a Bubble (see link: http://bigpicture.typepad.com/comments/2005/08/is_oil_a_bubble.html). A 90 year chart of inflation adjusted gas prices, at the link, suggest it is.

The past behavior of prices also implies that the reversion to prior mean (i.e., price collapse), when it happens, will occur over a long time period -- 5 to 8 years -- as opposed to a faster, Nasdaq-like collapse.

Posted by: Barry Ritholtz at August 14, 2005 02:48 PM

Looking at the June CPI release from the ONS, there’s a graph on page 4 of ‘12-month percentage changes’ in the components of the CPI:
http://www.statistics.gov.uk/pdfdir/cpi0705.pdf

Eight components made a positive contribution to inflation over the past year (all increasing above 2% individually) and four made a negative contribution.

The positive ones are mostly service related and are probably affected by higher oil prices.

The big negative contribution came from ‘clothing and footwear’ at –4.8% for the year. This negative inflation probably came from China and the weak US dollar.

But just as the price of oil can stop rising, the price of clothing and footwear can stop falling. China has started to revalue, the US dollar is rising along with rising US interest rates and the pound looks weak because, apparently, the UK economy is so sickly we need a rate cut.

Therefore, the brake on inflation coming from falling clothing (furniture and leisure goods) prices could be lifted very quickly. That just leaves those service companies passing on their costs.

If the oil price doesn’t drop soon the MPC could be facing 3% inflation faster than it thinks.

Posted by: David Sandiford at August 15, 2005 05:04 AM

Historically speaking, it looks like we could still have a way to go:

http://www.bp.com/liveassets/bp_internet/globalbp/globalbp_uk_english/publications/energy_reviews_2005/STAGING/local_assets/downloads/pdf/oil_section_2005.pdf

Yikes. I sincerely hope not.

Posted by: Rory Winston at August 15, 2005 04:48 PM

”If the oil price doesn’t drop soon the MPC could be facing 3% inflation faster than it thinks.”

CPI for July came in at 2.3% today, up from 2.0% in June. RPIX was 2.4%, up from 2.2%. Ha!

Well, no. The RPIX index didn’t rise at all from June. The average basket of goods and services cost the same in July 2005 as June 2005. It was only because the index fell in July 2004, but not in July 2005, that the annual inflation rate rose.

What’s going on? July is the ‘summer sales’ month. On average, RPIX prices usually fall at an annual rate of -4% in July; and then rise again at an annual rate of 4% in August. If that happens every year then there’s no change in the annual inflation rate in July, August or both months combined.

It didn’t happen that way in July 2005 – prices didn’t fall. Retailers didn’t reduce their prices in the summer sales the way they did in July 2004. Why?

My optimistic guess is that retailers had such a good June they didn’t need to shift unsold stock in a summer sale. My pessimistic guess is they reduced some prices but had to increase others to cover higher costs (because of oil or higher import prices).

We’ll have a better idea when we see the August figures. If the annual rate doesn’t fall back in August the MPC has an inflation problem on its hands.

Posted by: David Sandiford at August 16, 2005 11:42 AM

"The BoE voted five against four for a quarter point cut earlier in August and Governor Mervyn King was against the decision, the minutes showed."

We're lucky to have Merv.

Posted by: David Sandiford at August 17, 2005 10:06 AM
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