Oil Spike

The Return of the Hawks
June 12, 2008

By Joachim Fels & Manoj Pradhan | London

Central banks pound the table. Central bankers around the world continue to worry about ‘stag’, but ‘flation’ has now become their main concern. This is the loud and clear message sent by monetary policy decisions and hawkish comments over the past week or so. Just consider the following examples:



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The Return of the Hawks
Euroland
Oil Spike Shocks ECB into Action
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• The ECB Council last Thursday adopted a state of “heightened alertness”, and its President Jean-Claude Trichet said that a rate hike in July, while not certain, was possible.

• Fed Chairman Ben Bernanke in a speech on Monday noted that recent energy price increases had added to the upside risks on inflation and warned that the Fed “will strongly resist an erosion of longer-term inflation expectations”.

• The Bank of Canada surprised all analysts on Tuesday by not delivering the unanimously expected rate cut. Instead, the bank left the target rate unchanged at 3%, noting that the balance of risks for inflation had “shifted slightly to the upside”.

• The Swedish Rik*****ank will phase out CPIX, an alternative measure of inflation, and entirely focus on its target variable CPI, according to an announcement by Deputy Governor Wickman-Parak. CPI inflation is currently running at 4%Y against a 2.9%Y pace of CPIX.

• In EM countries over the past week, China announced a rise in reserve requirements by 100bp, Brazil and Chile hiked rates by 50bp, and Russia, Indonesia, the Philippines and Nigeria all lifted policy rates by 25bp. In Vietnam, the central bank hiked its base rate by 200bp to 14%.

The goal – anchoring expectations. These comments and actions are clearly aimed at anchoring longer-term inflation expectations at a time of surging actual inflation rates. Central bankers know that the going will get even tougher over the next several months as headline inflation looks set to move significantly higher on the back of the recent oil price spike. Our economists expect CPI inflation to rise above 5% in the US and to 4% in the euro area this summer. Against this backdrop, a firm anchoring of inflation expectations would help to contain second- and third-round effects of higher non-core inflation.

Markets now priced for hikes almost everywhere. The recent price action in money markets suggests that traders and investors are taking central bankers’ hawkish rhetoric seriously. Markets are now pricing in between two and three hikes of 25bp by year-end for the Fed, the ECB, the Swiss National Bank, the Rik*****ank and Norges Bank, and one to two hikes for the Bank of England, the Reserve Bank of Australia, the Bank of Canada and the Bank of Japan. Right now, New Zealand is the only developed economy where markets expect lower policy rates later this year.

Less tightening this year than markets think, except for the ECB. Our central bank watchers around the world remain less impressed by the hawkish rhetoric than the markets. The one notable exception is in the euro area, where Elga Bartsch now expects the ECB to follow up words with action in the form of a 25bp rate hike in July and another one later this year. Yet, in the US, the UK and Japan, our central scenario remains that policy rates will be left unchanged this year, as Dick Berner and Dave Greenlaw, David Miles and Melanie Baker and Takehiro Sato explain. Also, we don’t expect a tightening of monetary policy in Australia and Switzerland this year, even though the risks in these countries are probably skewed towards a rise. Norway and Sweden look likely to hike, but only once, and we maintain our call for 75bp of rate cuts in New Zealand.

Room for manoeuvre still limited. The main reason why we expect less tightening in most countries than markets price in is that we see growth slowing almost everywhere, and quite sharply in some cases. In the US, our economists look for a double-dip recession in the coming quarters. In Europe, our euro area team now sees GDP broadly stagnating in the next couple of quarters, and in Japan we also see a sharp slowdown in the current quarter. Moreover, the financial sector crisis is still lingering and further tail events cannot be excluded. Against this backdrop, we think that most central banks will lack the resolve to follow up hawkish rhetoric with (much) action.

Inflation genie is out of the bottle... Investors still appear to give central banks the benefit of the doubt – inflation expectations as (imperfectly) measured by breakeven inflation rates have increased only moderately in recent months. And the recent hawkish rhetoric has halted the increase for now. However, we continue to believe that inflation expectations are likely to rise further, following actual inflation, especially if the hawkish talk is not followed by action in most cases, as we suspect.

…as the global policy stance is very easy. As we discussed in previous publications, the underlying reason for rising global inflation is a very lax global monetary policy stance.

We looked at weighted nominal and real monetary policy rates, along with inflation, for the global economy and for the main blocs – G10, Asia ex-Japan, Latin America and Emerging Europe, Middle East & Africa. In each of these regions except Latin America, and in the world as a whole, real policy rates are in negative territory. To bring real rates back to neutral or even into restrictive territory, we would thus need to see either massive increases in nominal policy rates or a very sharp decline in inflation. Neither is particularly likely, in our view.

Inflation likely to be persistent. We looked at what would happen to the real monetary policy rate between now and end-March 2009 if central banks would in fact raise rates as implied by the money markets right now and if inflation behaved as our country economists are forecasting. Initially, the real rate would fall further into negative territory as headline inflation rises sharply in the next few months, but thereafter the real rate increases due to easing headline inflation and the rate hikes that markets expect. However, by end-March 2009, the real policy rate would only go back to zero in this simulation. In other words, monetary policy would still be expansionary at that point, unless one believes that the neutral rate of interest is zero too (we don’t). We conclude that inflation is likely to be a persistent problem in the years to come. This is not to say that inflation won’t fall after this summer. However, we are likely to see higher average inflation rates and higher peaks and troughs in the next inflation cycle(s).



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Euroland
Oil Spike Shocks ECB into Action
June 12, 2008

By Eric Chaney, Elga Bartsch & Carlos E. Caceres | London


Oil Shock = Higher Inflation + Slower Growth

Taking stock of the new oil price spike, we have significantly revised our inflation profile for this and next year, and cut our GDP growth forecast. In this challenging context, we think that the ECB has chosen its camp and is likely to take insurance against inflation infecting wage and price-setting mechanisms, at the risk of amplifying the cyclical slowdown caused by the oil price spike. Higher inflation and higher unemployment used to be the definition of stagflation in the 1970s. While we are not convinced that stagflation will become structural – thanks to more flexible labour markets and to the anti-inflation stance taken by the ECB – the infamous word will haunt the markets and investors’ minds for some time – at least until the middle of next year, we think.

A Supply-Side Shock of Magnitude 5

Until recently, the mainstream explanation for the vertiginous rise in crude oil prices since last year – even converted in a hard currency such as the euro, a barrel of Brent is now 61% more expensive than one year ago – was that the rise was demand-driven and originated in oil-thirsty economies such as China or the Middle East. However, the two most recent spikes in crude oil prices, from US$100/bl to US$125 in early May, then from US$128 to close to US$140 in early June, are pointing to structural changes in the oil market, which is suggesting that we are now facing a genuine supply-side shock. The nuance is important because a supply-side shock is by nature contractionary for the global economy, in contrast with a demand-driven change, where strong economic expansion is inflating input prices.

‘Peak Oil’ Reached for Non-OPEC Production?

The first change took place in the futures markets. In May, the shape of the long-term future curve evolved from backward-dated (long-term futures lower than spot quotes) to contango (a positive slope in the long end of the curve). This move was clearly illustrated by the dramatic move of the IPE contract for end-2016, from US$103/bl in early May (versus US$110 for the spot price) to US$139 at the end of the month (versus US$128 for the spot price). Since the cost of carry for crude oil is high, the normal slope of the curve is negative. The move toward a positively sloped curve has thus an important meaning: the trial-and-error process of market pricing was implicitly looking for a significantly higher equilibrium price. The best explanation we find for this change is that markets have come to the view that non-OPEC production has peaked. That non-OPEC production has systematically not met expectations over the last four years has given some support to the ‘peak oil’ theory. If non-OPEC production has indeed reached a plateau, the nature of the oil market becomes different: the cartel would be now in a position to influence the level of prices much more easily than when non-OPEC production was rising fast, as happened a few years after the 1979-80 oil price shock.

A ‘Creeping Supply Shock’

The second change occurred last week, when markets reacted to rising tensions between Israel and Iran by pushing up oil quotes by US$10/bl in a matter of hours. This price action provides strong evidence that the markets have also come to the view that there is not enough global spare capacity to extract oil, with non-OPEC production stagnating and OPEC appearing reluctant to increase output. As geopolitical tensions in the Middle East have dramatically increased over the last few years, market participants are constantly revising their subjective probability for a supply (of crude oil) disruption exceeding spare capacity. Although the markets have always been well supplied, as OPEC often reminds us, the risk of oil being suddenly rationed is so high that it has become the main factor driving prices, we think. For the global economy, there is not a fundamental difference between a virtual supply disruption which is sending prices through the roof, and a real one. In both cases, supply constraint, not excessive demand growth, is the cause of the price spike.

Consequence #1: Higher and More Resilient Inflation

In oil-importing regions such as the euro area, producers and, to a lesser extent, consumers have started to understand that the increase in energy prices is more likely to be permanent than temporary. That a growing number of companies have decided to pass, at least partially, the increase in energy prices to their own customers is testimony to a change in the mindset of managers: against a backdrop of weakening demand, companies would probably opt for a temporary squeeze in profit margins in order to keep their customers rather than raising their prices. Conversely, if the increase is permanent, they will have to pass it on sooner or later, with sooner being better. Because we think that the last spike is unlikely to unwind any time soon, we have taken the most recent future curve as our baseline. In order to figure out the impact of the oil price shock on inflation, we have embedded a more explicit modeling of the dynamics between non-core and core prices, as detailed by our colleague Carlos Caceres in another report (The Long Shadow of the Energy/Food Spike, May 19, 2008).

Based on this study, our belief is that a significant amount of input cost-push inflation will show up in the next 12 months. In addition, the dramatic decline of the unemployment rate in the euro area, from 8.9% at the end of 2004 to 6.9% in March 2008, seems to have started to generate significant wage pressures, at least in some countries. It is not obvious that companies will fully pass the rise in nominal wages onto prices, since it might prove temporary, but it is reasonable to expect that they will do it partially. In sum, we see HICP-based inflation rising to 4.0% or slightly higher in the next six months, averaging 3.7% this year and 2.9% next year, provided that oil markets stabilise. It is only in 2010 that we see inflation landing close to the ECB comfort zone, at around 2.0%, thanks to the cooling effect of below-potential GDP growth over an extended period of time.

Who Is Going to Foot the Bill of the Oil Price Spike?

Back in 1999-2000, when the price of oil had increased by more than 200%, we had estimated that wage earners had paid 80% of the oil bill, i.e., of the incremental income transfer from euro area economies to oil exporters, as wages had not followed headline inflation for lack of bargaining power (see Who Paid for the Oil Shock? by Eric Chaney and Anna Grimaldi, July 2, 2001). This time might be different, as wage earners’ bargaining power is probably benefiting from the drop in unemployment we have already mentioned. While nominal wages are largely disconnected from headline inflation, at least in the short term (obviously, in the longer run, wages are fully indexed; otherwise, the wage share would converge to zero), we think that the acceleration of wages that we anticipate will result into a more evenly shared burden.

Consequence #2: Euroland on the Verge of Recession

Practically, this implies that both real disposable income and real profits will suffer from the oil price spike. We do not think that consumers will take on their savings to maintain their living standards, because higher inflation is also an incentive to rebuild non-inflation-protected cash balances. Accordingly, we have substantially revised down our consumer spending forecasts, from 1.5% to 0.7% this year, and from 1.9% to 1.1% next year. With real profits contracting this year in a context of tighter credit conditions, companies are likely to slash investment projects even more than we had previously anticipated. Because, until recently, corporate investment was particularly buoyant, the full effect of the oil-induced supply-side shock will be more visible in 2009, when we anticipate that fixed investment will flatten. Overall, weaker demand and weaker profitability will converge to push the euro area close to recession in the next few quarters. In the very short term, a correction in the weather-sensitive construction sector after an exceptional 1Q is likely to darken the picture excessively. With no support from consumers, we anticipate a slight GDP contraction in 2Q. Yet, looking forward, we see GDP growth remaining significantly below trend until 2Q09, when, thanks to declining inflation and a brighter global outlook, domestic demand may accelerate somewhat. We have marginally trimmed our GDP projection for 2008, from 1.6% to 1.5%, and this despite the upward revision to 1Q GDP growth, and cut our 2009 projection from 1.4% to a mere 1.0%.

ECB: Up, Not Down

The switch in our forecast is due to a rapidly deteriorating inflation picture that is only partially offset by a slowly sliding growth outlook. A first refi rate increase from the ECB could come as early as July. A July rate hike is unlikely to mark the beginning of an aggressive tightening campaign by the ECB though. Yet, in the light of another adverse shift of the growth-inflation mix, the ECB will likely want to insure against potential second-round effects and ensure stable inflation expectations. The first move will thus likely be followed by another one. A stronger currency and persistent money-market tensions will likely contribute to tighter monetary conditions. As a result, we would not rule out the euro area yield curve, which has dipped into the red again, staying inverted for some time.

What Has Changed?

In March, we caved in and called for an ECB interest rate cut in late 2008 in response to a marked reduction in our growth outlook by three-quarters of a percentage point over this year and next against the backdrop of a benign medium-term inflation outlook (see From ‘Soft Rebalancing’ to ‘Conflict of Interest’, March 19, 2008). At the time, we felt that the spike in headline inflation would be short-lived and that inflation would be back to 2% in early 2009. While our growth outlook still shows an average 1.3% over 2008/09, the inflation picture has deteriorated sharply. Back in March, we expected inflation to average 2.9% this year and 2.1% next year. Now we are showing 3.7% and 2.9%, respectively. And it’s not just oil and food. Core inflation is also creeping higher on our revamped forecasts. Previously, we estimated that core inflation would remain well contained between 1.5% and 1.7%. Now we believe that core inflation could climb to around 2.5% in the course of next year.

A Rate Hike in July Is Likely, but Not Yet Certain

While we continue to believe that a ‘state of heightened alertness’ signals a different degree of certainty than ‘strong vigilance’, a July rate hike now should be the main case scenario for investors, albeit only by a relatively small margin. There is still an outside chance that a turn for the worse in the data and news flow from economic activity, financial markets or money and credit growth could create a significant enough minority on the Council opposing the move for the ECB to adopt a wait-and-see approach. On balance, however, it would probably take some sizeable surprises to swing the Council around between now and early July.

Refi Rate Peaking at 4.5%? A Third Hike Cannot Be Excluded

Beyond the near term, there is probably scope for another rate rise in the remainder of this year. This would bring the refi rate to 4.5% by year-end, a level that we would consider to be at the upper end of the neutral range. Given that even after two more rate hikes, monetary policy would not yet be clearly restrictive; the risks to our forecasts are probably tilted to the upside in 1H09. But given that growth on our forecast now slows down to 1% next year, rather than the recovery shown in the ECB’s own staff projections, we feel that a third rate hike would be a push.

With the Federal Reserve firmly on hold until next spring, according to our US colleagues, Richard Berner and Dave Greenlaw (see US Economics: The Double-Dip Supply Shock, June 9, 2008), the transatlantic monetary policy divide will thus deepen further between now and year-end.

Internal Political Tensions Are Likely to Heat Up

Within the euro area, political tensions are likely to rise along with the misery index – defined as the sum of consumer price inflation and the unemployment rate. As a result, some rifts between different countries or different groups of countries will likely emerge, depending on their relative economic performance at this stage of the business cycle, their sensitivity to interest rate changes and their social costs associated with an unexpected inflation overshoot. The latter will likely be determined by the degree of indexation of wages, pensions and other benefits, the share of inflation-protected assets held by private households as well as the inflation preferences in society. Monetary policy will likely become more ‘noisy’ and the discussions in the ECB Council more controversial. The consequences of a tougher stance on inflation might also be felt further afield.

A New Risk Scenario: A Full Blown Oil Shock

As tensions in the Middle East increase again, a large oil supply disruption, of more than 3 mb/d (i.e., around 6% of internationally traded oil), is becoming more than a remote possibility. We think that it would result in a global recession, under the combined effect of oil rationing, which could wreak havoc on highly oil-dependent economies, and of the inevitable large price spike that would result – maybe another doubling in the real price of oil. Only rich countries or those running large current account surpluses would be able to import the oil that their economies need. Demand destruction, which has already started in countries where end users get the price signals, would certainly accelerate, as well as substitution and conservation. Yet, as long as supply is severed by political events, the price of oil is likely to remain very high for longer, thus creating a risk of more resilient stagflation for the global economy. In these circumstances, we believe that the euro area would weather the shock relatively well, thanks to the strength of the euro and to its limited dependency on oil imports, a legacy of the adaptation of European economies to the 1979-1980 oil price shock.



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