Monday, August 29, 2005

Why Oil's Surge Hasn't Damped Global Growth

Prices, Interest Rates Stay Low, While Property Boom Keeps Consumers Spending

By BHUSHAN BAHREE Staff Reporters of THE WALL STREET JOURNALAugust 29, 2005; Page A1

The near-doubling of oil prices -- to $70 in the past 24 months -- has had surprisingly little impact on the pace of global growth, as other broad economic factors have helped damp the damage inflicted by previous oil-price shocks.

The global real-estate boom and a flood of cheap goods from Asia have enabled consumers, particularly in the U.S., to continue spending despite higher energy prices. The bond market has kept long-term interest rates low, providing a stimulus to the economy that has offset some of the restraint that sharply higher oil prices usually produce. And the Federal Reserve and other major central banks, enjoying the credibility that comes with their success in keeping inflation low, have held short-term lending rates relatively low, in sharp contrast with the oil shocks of the 1970s and 1980s.

Moreover, in contrast with past episodes, this surge in oil prices stems more from global economic vigor -- the strong demand for oil from China and the U.S. -- rather than producers' manipulative tightening of supply or fears about Middle East conflicts disrupting supply.

"The cost of continuing economic growth will be rising oil prices," says Philip Verleger Jr., an oil economist and senior fellow at the Institute for International Economics in Washington. Oil prices may well rise to $100 a barrel, but that alone wouldn't trigger a recession, Mr. Verleger says. The rise in oil prices "ends when the global real-estate bubble bursts."

While crude oil-prices recorded another record in nominal terms last night, the record in inflation-adjusted terms would be over $90 in April 1980. Energy futures spiked Sunday evening, as traders got a chance to react to the new and dire course charted by Hurricane Katrina. In overnight electronic trading on the New York Mercantile Exchange, October crude-oil futures opened up more than $4 from Friday's close of $66.13, topping $70 a barrel for the first time.

The oil industry Sunday braced for severe damage reports from Hurricane Katrina as the storm moved through the heart of the U.S. Gulf Coast oil-production and -refining system yesterday.
Any major supply disruption, whether from Katrina or another quarter, could quickly turn the present oil crunch from relatively benign to nasty if even higher prices force consumers and companies to curtail other spending to pay energy bills. That is a particular concern in the U.S., where consumers have drawn down their savings substantially and there are signs that the housing boom, which has helped stoke consumer spending, may be cooling off.

The price of oil has been rising for two well-known reasons: Supplies are constrained after years of underinvestment, and demand is booming as fast-growing nations gulp ever-more fuel. The puzzle for economists has been why the price increase hasn't done more to slow growth.

orecasts for economic output remain upbeat, with global gross domestic product on track to expand 4.3% this year, down from 5.1% last year, the fastest rate in a generation, according to International Monetary Fund data.

Oil-price spikes can hurt the economy by acting as a tax on consumption, forcing people to spend less on other goods, and by raising the costs and crimping the profits of companies. But on both fronts, broader economic forces have been offsetting the oil shock.

Global competition has helped keep inflation in check. Nearly one-third of the 3.2% increase in U.S. inflation in the past year, as measured by the consumer-price index, has been due to rises in energy prices, including gasoline, natural gas and heating oil, according to Bureau of Labor Statistics data.

Cheaper imported goods are replacing American ones or forcing U.S. manufacturers to hold down their prices. Imported goods from the Pacific Rim countries, which account for one-third of all U.S. imports, have fallen in price by 0.2% since December 2003, according to data from the Bureau of Labor Statistics.

Oil prices aren't boosting wage inflation either. In the oil shocks of a generation ago, companies indexed workers' earnings to inflation and doled out raises amid the rising oil prices.

"Global labor markets are keeping wages under control," says Joseph Quinlan, chief market strategist for Bank of America. But he adds that inflation is an increasing risk. The Fed targets core inflation, which strips out energy and food prices, and is now running at slightly over 2%, the top end of the Fed's comfort zone.

What's more, the wealth effect of the boom in housing prices alone has enabled many U.S. households to pay for pricier energy and continue spending more on everything else -- from clothing and cars to vacations. This year, at least, that trend is expected to continue.

In 2004, Americans extracted $140 billion from their homes in "cash out" mortgage-refinancing deals, in which they borrowed against the equity built up in their homes. Mortgage-finance company Freddie Mac expects them to draw an additional $162 billion this year through cash-out refinancing. Capital gains on home sales and booming home-equity loans have been additional financial resources for many households.

Gasoline consumption in the U.S. rose 1.6% in the latest four-week period from a year ago, even though prices at the pump were up 73 cents a gallon, or 39%, on the year. U.S. households spent about $276 billion on gasoline and oil on an annualized basis in the second quarter, nearly $76 billion more than two years ago, according to data compiled by the U.S. Bureau of Economic Analysis. But Americans also spent $41 billion more on clothing and shoes in the latest quarter compared with two years ago, not to mention tens of billions of dollars of additional outlays on furniture, health care and recreation.

The bigger energy bill is painful, of course -- but not enough to hobble the economy. Fed Chairman Alan Greenspan said in a speech in May that the rise in the value of imported oil -- essentially a tax on U.S. residents -- amounted to about three-quarters of a percent of GDP. "But, obviously, the risk of more serious negative consequences would intensify if oil prices were to move materially higher," Mr. Greenspan said.

Oil prices are now $16.30 a barrel above their May levels. Although the U.S. economy in 2004 was more than twice the size it was in 1979, the Energy Department says the nation consumed only 9% more petroleum, primarily because it has become more energy-efficient.

On Friday, Mr. Greenspan suggested he isn't very worried by the rise in energy prices: "The flexibility of our market-driven economy has allowed us, thus far, to weather reasonably well the steep rise in spot and futures prices for crude oil and natural gas that we have experienced over the past two years." But he also warned that the recent rise of stock and house prices reflects greater willingness by investors to accept risk, leaving markets vulnerable to an "onset of consumer caution."

The Department of Energy's rule of thumb suggests oil prices haven't risen high enough to cause recession. "Every 100% increase in the price of oil sustained over a year can reduce [U.S.] GDP growth by one point from what it would have been," says Nasir Khilji, an economist at the DOE's Energy Information Administration. Oil prices have risen by about 84% during the past two years, comparing the average price in the second quarter this year with the same quarter in 2003.

Also limiting the fallout has been the slow unfolding, over 2½ years, of this oil shock, which has allowed central bankers and consumers to manage the blow. In 1973-74 and 1979-80, prices tripled in just weeks or months after supplies were cut.

The sudden jumps in the 1970s came amid already high levels of inflation, and provoked quick and sizable interest-rate increases by central banks fearful of a runaway wage-price spiral. Officials at the Fed and other central banks have studied those shocks closely, and many have concluded that the sky-high interest rates were the primary cause of the recessions that followed.

After the first oil crisis in 1973, the U.S. federal-funds rates peaked at 13% in May 1974, up from 5.75%. As the Iranian revolution unfolded some years later and oil prices soared again, the federal-funds rate went from 6.5% at the start of 1978 to a peak of 20% in May 1981. Severe recessions ensued both times.

This time, amid the lowest rates of inflation in decades, the Fed kept trimming its funds rate until it reached a 46-year low of 1% in June 2003. It has been gradually raising the rate since June last year, with the latest increase in August bringing it up to 3.5% in a trend that is widely expected to continue.

Instead of oil prices driving monetary policy, policy may now be driving oil prices. "The Fed overstimulated the economy in 2002 and 2003," says James Hamilton, a professor of economics at the University of California at San Diego. "That had nothing to do with oil prices." But one consequence of the overheated economy was a rise in oil use and its price. Now, the ratcheting-up of short-term interest rates may result in a slowdown in the next six to nine months, Mr. Hamilton says.


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