Is the World Economy Less Sensitive to Oil Prices?

The impact of oil price changes on economy has been a controversial debate since early 1970s when high inflation amid a severe economic recession lambasted industrial economies following the oil embargo of the Western World by Arab nations. It still remains contentious as quantifying the impact of an oil price shock on economic activities has proved to be difficult with significant difference over short or long run. The impacts also depend to the structure of the economy of concerned as well as economic policies adopted by the authorities. The size of the shock and its persistence, the oil and energy intensity of the economy and the policy response of the authorities are amongst the main determinants of the impact of an oil price shock on economic activities, employment and inflation. This should be noted, however, that while all post 1970s recessions have been associated with oil price shocks, not all oil prices increase lead to recession (see chart below where for example 2003 and 2006 increase in oil prices are not followed by recessions). Figure1. Oil prices, recessions and inflation trends in the US, 1970-2011
140 120 100 80 60 40 20 0 1970 - Jan 1971 - Jan 1972 - Jan 1973 - Jan 1974 - Jan 1975 - Jan 1976 - Jan 1977 - Jan 1978 - Jan 1979 - Jan 1980 - Jan 1981 - Jan 1982 - Jan 1983 - Jan 1984 - Jan 1985 - Jan 1986 - Jan 1987 - Jan 1988 - Jan 1989 - Jan 1990 - Jan 1991 - Jan 1992 - Jan 1993 - Jan 1994 - Jan 1995 - Jan 1996 - Jan 1997 - Jan 1998 - Jan 1999 - Jan 2000 - Jan 2001 - Jan 2002 - Jan 2003 - Jan 2004 - Jan 2005 - Jan 2006 - Jan 2007 - Jan 2008 - Jan 2009 - Jan 2010 - Jan 2011 - Jan USA Recession Average Spot Price of Crude Oil, US$/bbl (LHS) USA CPI Y-o-Y % Chg (RHS) 16 14 12 10 8 6 4 2 0 -2 -4

The nature of the oil price shock depends largely to whether oil price increase is a demand pulled increased or whether the shock is caused by an unexpected disruption in oil supply. If an unexpected increase in oil prices is driven by an unexpected boom in world economic growth, the higher oil prices might moderate the initial boom but do not cause a downturn. However, supply shocks caused by geopolitical events or a permanent decline in availability of oil are likely to raise oil prices regardless of global economic conditions, and depending on the

magnitude of the supply disruption, may cause a loss of output (IMF, WEO, April 2011). Having recognized the differences in the nature of an oil shock originated from supply disruption compared to a demand pulled price rise, however, a serious issue is the difficulty of sorting demand from supply shocks. Some prominent economists (Rogoff, k. (2006), Barsky and Killian (2002) for example) have argued that most of the major turns in oil prices have a large endogenous components, reflecting spikes in demand, and not simply actual or anticipated interruption in supply. Straight forward statistical attempts to corroborate the significance of oil prices impact on economy seem to support the important role of oil as leading indicators of economic activities1. The questions remain, however, on the channels through which oil prices affect the economic activities, the magnitude of the impacts and their persistence. Let us take the magnitude question first. The share of oil in the cost of production should shape most of GDP impact of an oil price shock. Although oil is either a direct or an indirect input of production process for many goods and services, its overall cost as a proportion to GDP is quite small, ranging from 2 to 5 percent indifferent countries (IMF, WEO, 2011, Rogoff, K., 2006). In principle, the elasticity of GDP with respect to an oil price change, induced by for instance a supply shock, should be about equal to that of the cost share. For example, we have estimated the following price elasticity of demand for oil for G7 (including Canada, France, Germany, Italy, Japan, UK and USA), and the BRICs (Brazil, China, India and Russia) as follow: Table1. Price elasticity of demand for oil in G7 and BRICs (1990Q1-2011Q2) G7 Short run -0.055 BRICs -0.045 All 11 economies -0.05

Assuming a fixed energy mix in the short run, a 30 per cent increase in oil prices would raise oil cost in these economies about 1.5% of their GDP on average. But in real world the impact of a 30 percent increase in oil price can be different in each of the countries of the sample group.

Simple Granger Causality tests between the co-integrated quarterly series of USA and Chinas real GDP and real WTI (1990Q1-2011Q2), indicate that one cannot reject, at usual 5% level, oil prices movements predictive power for output. The tests for first differences of the series (GDPt -GDPt-1 and WTIt-WTIt-1) yield the similar results when the lags extended to six. Lags: 2 Null Hypothesis: WTI does not Granger Cause GDP_US GDP_US does not Granger Cause WTI WTI does not Granger Cause GDP_China GDP_China does not Granger Cause WTI Obs 84 F-Statistic 4.00618 2.50020 3.36142 2.80907 Prob. 0.0220 0.0885 0.0397 0.0663

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This is argued that while there are channels through which an oil price spike (30 percent as in our example), could exert impacts greater than what the cost share of oil in the economy would imply, but on the other hand certain factors and policy response can reduce the negative impact of oil price shock on the economy. Uncertainty caused by an oil shock is one important amplifying factor of the impact of an unexpected oil price increase on economic activities. Both firms and household are affected by uncertainties about the future economic prospects and this may cause postponing their consumption and investment decisions. An oil shock, on the other hand, could cause supply side difficulties as oil intensive sectors of the economy might find their profitability diminishing due to a larger increase in their cost of production relative to other sectors. If the shock persisted, oil intensive industries might have no choice but to cut their output. Trying to pass higher price of input on to consumers would reduce demand for their products eventually. Reallocation of inputs and technological changes would take time and might be costly. In severe cases, bankruptcies from oil and energy intensive industries could spread to rest of the economy. Thus interplay of these channels could amplify the negative impact of an unexpected oil shock on the economy. Despite the fact that an oil shock could have far reaching impact on economies with vulnerable conditions, generally speaking there is a consensus now that most consumer countries are less susceptible to oil price shocks today compared to, say, 1990s. The reasons vary by country and region, however, factors contributing to macroeconomic stability of oil consuming nations, when facing an oil shock, include greater oil efficiency, concentration of oil consumption in transportation and final demand that reduce the idle capital equipment when there is an oil shock, deeper financial markets and better monetary policies that prevent damaging secondround effects on wages, flexible capital and labour markets that allow for reallocation of inpurs and reduce wage rigidities, amongst others. Reviewing the results disseminated from empirical researches, it seems that, although reduced greatly, but it would be wrong to rule out possibility of any oil-induced recession in the future. However, considering the fact that in most cases of economic recessions of the past decades, oil price have been affected by combinations of demand side effect and oil supply rigidity, disentangling demand pulled oil price increase from the shocks caused by supply disruptions is a key part of quantifying the relationship between oil prices and economic activities. References, Barsky, R. and L. Killian,(2002) Oil and Macroeconomy since the 1970s. Journal of Economic perspectives 18:4, pp 85-106 (International Monetary Fund, (2011) World Economic Output. Killian, L (2006) Exogenous oil supply shocks: how big are they and how much do they matter for the US economy? Working papers, University of Michigan, Department of Economy . Rogoff, K. (2006) Oil and the Global economy