Sunday, December 07, 2008
Crude's collapse oils the Bank's wheels
Posted by David Smith at 09:00 AM
Category: Thoughts and responses


Another week, another point off Bank rate, coupled with a 0.75 point cut by the European Central Bank. The dive in official interest rates towards zero is an extraordinary facet of an extraordinary time.

After a cascade of bad news, notably very weak purchasing managers' surveys for manufacturing, construction and services, the Bank had no option but to go for another cut that only a few weeks ago would have been regarded as unthinkable.

Activity is sliding fast everywhere, and certainly in all advanced economies. The OECD reckons the fourth quarter will see the biggest gross-domestic-product declines in this recession (Britain contracted by 0.5% in the third) and it feels that way. Much depends on when policy actions, including aggressive rate cuts, start to have an impact.

Members of the Bank's monetary policy committee (MPC), having taken these dramatic steps, are feeling a bit misunderstood. They think people do not appreciate the pressures they were under until recently to balance rising inflation and people's heightened expectations of future inflation and recession.

And, while I would have liked to see them cut aggressively much sooner, they have a point. In August, before the near-meltdown in the global banking system that started with Lehman Brothers' bankruptcy in mid-September, only two forecasters out of 44 monitored by the Treasury were predicting outright recession in 2009. They were Standard Chartered and Peter Warburton's Economic Perspectives.

The consensus among forecasters was that Bank rate would remain at 5% until the end of the year, falling only gradually to 4.25% by the end of 2009. Inflation would remain above the 2% target throughout. Things have changed, and they have changed dramatically.

We know about the damage this most deadly phase of the financial crisis has inflicted on growth and confidence. It has also transformed inflation prospects, and one useful measure of this is the oil price. In August, economists expected the price to average $115 a barrel in 2009. It had come down from its July record of $147 but most did not expect it to come down much more. Last week Brent crude dropped below $40, a figure that seems strangely familiar.

The oil price and I go back a long way. Having repeatedly said the price rise was a spike, significantly driven by speculation, I found myself at odds with many apparent experts and many readers.

T Boone Pickens, the legendary US energy investor, said oil would never again go below $100 a barrel and his view was echoed by many lesser lights. Some journalists went out of their way to deny a speculative element in the spike, even as some investment banks continued to pump up the oil story and funds poured into commodity-index futures. Arjun Murti, Goldman Sachs's energy strategist, said the price could reach $200 in the second half of this year and plenty of rival banks pushed the rising oil story. Jeff Rubin, chief economist at CIBC World Markets, was also a $200 man.

Peak-oil enthusiasts explained every price rise as further evidence that global production had reached its maximum. Weekly rags spouted "sell your house, buy commodities" nonsense. I hope nobody did.

The more the financial crisis dragged on, at least until the September-October tumult, the more oil bulls became certain the price of crude would continue to rise. That seemed illogical to me. Even before the latest banking troubles the world economy was heading into a period of slower growth and restricted oil demand.

That did not stop the vested interests, like Chakib Khelil, the Opec president, who predicted a rise to $170 this year, or Alexei Miller, chief executive of Gazprom, who summoned journalists to an awayday in Deauville to say the price would hit $250 "in the foreseeable future".

We have to be thankful they were wrong, though not before such views, in helping to drive the oil price higher, did a lot of damage. The scale of the market turbulence and intense banking strains of recent weeks took everybody by surprise and hastened the fall in the oil price because some investors were forced to unwind their speculative positions. But its main effect was to bring forward the inevitable.

In the short term, then, this is unalloyed good news. The full-year effect of a sustained oil drop from nearly $150 to $40 a barrel is, according to Mark Cliffe, global head of financial-market research at ING, a $2,700 billion transfer from producing to consuming countries. This is a tax cut much bigger than the one western governments are implementing.

More directly, the oil fall has liberated the Bank, and other central banks, in spectacular fashion. The mainstream view now is that retail-price inflation will go negative during 2009 and consumer-price inflation will skate close to zero.

Will it go below zero and, in a recessionary environment, usher in a long and potentially devastating period of deflation a falling price level? The danger of that is not that people delay purchases in anticipation of further price falls; that is an everyday story on the high street. It is that debt, already at high levels, becomes even more burdensome by rising in real terms.

The Treasury, which sees consumer-price inflation falling to 0.5% by the end of next year, thinks it will then bounce. "Inflation is forecast to move a little above the 2% target following the reversal of the Vat cut and as the lagged effects of sterling depreciation on import prices continue to feed through," it said in the pre-budget report.

Part of the path of inflation, however, is dependent on oil. After previous recessions the oil hangover was long. In the mid-1980s and 1998 the price touched $10 a barrel as demand took time to recover.

The medium-term supply-demand balance for oil should be tight enough to avoid that happening again and, indeed, it would not be a good thing if it did. Already weak oil prices and funding shortages are scaling back exploration and development.

The appropriate price of oil is one that encourages marginal fields to be brought on stream. If it falls too far below present levels, says the International Energy Agency, we will be storing up supply problems for the future by discouraging development.

The fall in the oil price is a good thing. Like many good things, however, you can have too much of it.

PS: As a paid-up member of what George Magnus calls the "boomerangst" generation baby-boomers worried about their retirement I have been reading his book, The Age of Aging (Wiley, 17.99) with interest.

The golden age of retirement, which in Britain probably meant people retiring on good company pensions in the 1990s, is over, at least in the private sector.

Boomers retiring now, after the stock-market carnage of the past 12 months, are particularly badly hit. According to Magnus, UBS's senior economic adviser, defined-contribution plans in Britain have lost between 30% and 40% of their value in the past year, while those in the US have fallen by about $2 trillion.

We will all, it seems, have to work longer. That's easy to think about when the job market is strong. In a recession the opposite is likely to occur.

From The Sunday Times, December 7 2008