Oil prices have fallen sharply from their lofty heights in the middle of 2014, but the demand boost that economic theory tells us to expect has simply not materialised. This is perplexing to economists and market commentators alike. However, the complexity of modern financial markets and their intertwining with the real economy may help us to solve this conundrum, according to Eoin Murray, Head of the Investment Office.
Traditionally we have believed that oil price declines would provide a net positive boost for the world economy, the balance between a negative effect on the growth of exporters more than offset by a positive effect for importers of the commodity. Instead we have seen a strong positive relationship develop between the oil price and equity markets, with a near doubling of the correlation. Those same equity markets have broadly reflected the continuing difficult economic conditions that we find ourselves in some 80-odd months post-recession.
Of course we might need to differentiate between oil price declines brought about through an increase in global supply versus those that occur due to a drop in global demand. The latter phenomenon could partly explain what we have observed – slowing global growth cushioned by lower oil prices. Indeed, a number of recent academic studies suggest that slowing global demand may account for as much as a half to a third of the fall in the price of oil.
For lower oil prices to feed through to positive economic growth, one would typically expect a boost in spending, but we have not seen any evidence of that this time – rather, public investment has been falling, and many countries have no capacity for any additional borrowing that could provide the necessary stimulus. And the size of the current decline has had a significant direct effect on capital expenditure in the oil and gas sectors too, with knock-on effects to other parts of the economy.
Following the global financial crisis, all major central banks have been pursuing unconventional monetary policy of one form or another – this has left them in a position of not being able to further lower rates to support growth alongside the reduction in oil price. A fall in long-term inflation expectations can feed through to stifle the increases in output and demand that we would otherwise expect.
The failure of producers to agree to hold output steady at their recent meeting obviously weighs heavily upon the supply problem in the short term, but there is reason to hope that ultimately the drop in the oil price will be expansionary at the global level. Today’s price war is holding the price down, but eventually we should see a fall in supply and a higher price in the future.
This current episode of lower oil prices has come at an unusual, and to some extent unprecedented, time for the global economy. As such we have seen unexpected dislocations and feedback loops that require us to reconsider the effects of lower oil prices, at least in the short term.