Monetary policy, output growth and oil prices.

Barrell, Ray ; Delannoy, Aurelie ; Holland, Dawn 等

As the global recovery strengthens, attention has to focus once again on the price of oil. The sharp increase seen in the last quarter of 2010 has raised serious concerns for the economic outlook. Oil prices have risen significantly since the beginning of 2009, and the rate of increase suddenly accelerated in the last months of 2010. Between September and December 2010 alone, oil prices rose by about $20, to reach $95 per barrel. Figure 1 compares the expected path of the oil price used in our forecast in October 2010 to that in January 2011, based on information from forward markets as well as an evaluation of supply conditions.

The oil market has been highly volatile in recent weeks. Volatility is a common characteristic of this market, especially when it is searching for a new equilibrium, but the futures market for oil suggests that the recent upward step in the oil price is likely to be permanent, with the rate of expected oil price increases from 2012 unchanged from three months ago. There is a heightened risk that prices may rise above current projections. Strong concerns about political instability in the Middle East have emerged with the recent protests taking place in Tunisia and Egypt. Some signs of civil unrest have also appeared in Lebanon, Algeria and Yemen. The Middle East currently supplies about a third of the world's oil and possesses over half of the world's proven reserves; instability in the region automatically raises risks of supply disruptions and possible oil shortages. The fear of future oil disruptions has already affected speculators' behaviour in the oil market, and the effects could intensify if governments try to prepare for further price increases by stockpiling oil, which will put short-term pressure on demand.

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Recent price pressures may be the result of rapid growth in oil demand, notably from emerging economies such as China and India. China has been the primary source driving the rise in global demand for oil in recent years. Figure 2 illustrates the global shares of production, consumption and proven reserves of oil in 2009. Consumption of oil in China and India far exceeds production, and with these economies expected to grow by more than 7 per cent per annum over the next decade, their demand for oil is expected to continue to expand rapidly. Increased demand for oil has also originated in several advanced nations where the economic recovery is now well underway. At the bottom of the global recession of 2008-9, world oil demand fell for the first time since the 1980s, but has subsequently recovered pre-crisis levels. The US Energy Information Administration data for the third quarter of 2010 displayed the largest gap between oil demand and supplies since 2007, and it is not surprising that this has led to upward pressure on the price of oil. The recent strengthening of demand for oil has added to supply pressures, in a situation where the expectation of tighter regulations following multiple recent oil spills has put upward pressure on long-term price expectations, while the weakening of the US dollar has put upward pressure on prices in the short term.

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Global oil prices are denominated in US dollars, but the impact of a rise in prices on individual economies will depend more on the price in domestic currency, and relative to the domestic price of other goods. Figure 3 plots exchange rate adjusted real oil prices for the UK, the US and the Euro Area. (1) The recent weakness of the US dollar has meant that the full impact of the rise in the dollar oil price has been partly offset by the exchange rate in the UK and the Euro Area. Nonetheless, real prices in these regions are expected to approach the peak levels of 2008 and the early 1980s in the next two years. In the US, the real oil price is expected to remain somewhat below its peak value in 2008.

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High and rising oil prices cause people to worry about inflation, in part because they do induce upward pressure on average prices, and also because historical shocks were associated with the high inflation experienced in the 1970s and early 1980s. Increased oil prices also affect sustainable output as oil is an input into production, and sustained increases in oil prices can lead to periods of rising inflation and slowing growth.

In this note we use our global model NiGEM to look at the consequences of oil price shocks. The impact effects are determined largely by usage and by exchange rates, but in the medium to long term they depend upon the conduct of monetary policy, as we show. We also look at the recent movement in the yield curve in the US, and calibrate the impact of quantitative easing measures introduced in the final quarter of 2010 after factoring out the expected interest rate response to the oil price rise.

Oil and the real economy

High real oil prices are expected to reflect negatively on economic growth in many countries, although these effects may be less significant than they were in the 1970s, largely because the volume of oil (or rather fossil fuel) use has fallen as a percentage of real output, as can be seen from table 1. Oil intensity of production in the US has declined from 12.3 per cent of GDP in 1975 to 5.4 per cent of GDP in 2010. Oil intensity in the Euro Area has also nearly halved over this period, but is significantly lower than in the US, amounting to just 3.3 per cent of GDP in 2010. Oil intensity in China and India is far higher than in the advanced economies, as one might expect in an emerging market, although this partly reflects the difference between the market exchange rate, which is used to calculate the value of oil usage, and the purchasing power parity rate, which is used to calculate the level of GDP.

Table 2 reports the value of oil use as a share of nominal GDP, which indicates the share of producer costs required to purchase the necessary oil for input into the production process. This share moves in line with the nominal oil price, as a higher oil price demands a greater share of input costs and there is little scope for volume adjustments in the short term. In value terms, the share of oil in GDP has fallen in all the advanced economies since 1980, when real oil prices were at similar levels to those we currently see. The value share in 2010 is broadly in line with the share in 2006 in the Euro Area and the US, but it has increased somewhat in the UK, due to the weaker exchange rate.

The effects on the US economy of the recent rise in the oil price could be more severe than elsewhere due to its high energy use compared to other countries, such as France and Germany. The Chinese and Indian economies are far more oil intensive than most nations, but the effect of the price increase is limited by important subsidies on oil products for domestic consumers. China's oil consumption has increased nearly fourfold since 1980, reaching about 10 per cent of total world consumption, making China the second biggest oil consumer in the world after the US. China was a net exporter of oil until the early 1990s, whilst about half of oil consumed in China is now sourced from abroad. The increase in energy imports into China make it more vulnerable to shocks than in the 1970s, as its terms of trade change, and any target current account has to be hit with a higher volume of exports of goods and services, whereas the sensitivity of the advanced economies has come down significantly since the oil price shocks of the 1970s and 1980s.

It is important to distinguish between the short-term and long-term effects of a rise in the oil price on the macroeconomy. The initial impact comes through prices. Oil is an important input into the production process, as we discuss above, with the volume of fossil fuel use amounting to 2 1/4-5 1/2 per cent of GDP in the US and Europe. An unexpected rise in the oil price will raise the input costs of production. Firms can be expected to pass some of this rise in production costs onto consumers, with a greater degree of pass-through if the oil price rise is viewed as permanent rather than temporary. Household budgets are more or less fixed in the short term, and the volume of consumption is likely to decline relative to the level that had been anticipated, although this may be partially offset by a decline in savings. The short-term impact differs across countries due to differences in the oil intensity of production, as well as the degree to which firms absorb price rises in the short term, liquidity constraints and the scope for consumption smoothing by households, and other differences in product and labour market flexibility.

In order to assess the expected short-term impact on output and inflation of the recent rise in the oil price, we run a model simulation where the oil price is raised by the difference between expected oil prices in January 2011 and October 2010, as illustrated in figure 1 above, which entails a rise in oil prices of $18 per barrel in 2011 and $25 per barrel by 2017. Below we discuss the important role of the monetary policy response to the oil price rise. However, the simulation results for the first year are largely invariant to the interest rate feedback rule and can be thought of as short-term impact multipliers.

Figure 4 illustrates the expected impact of the recent rise in the oil price on output and inflation in the US and major European economies in 2011. The short-term inflationary impact is expected to be higher in the US, Spain and Italy than elsewhere. In the case of the US this reflects the fact that the volume of oil used in production is about twice that in Europe relative to the size of their GDP, whereas in Italy and Spain the higher impact on inflation is also partly a reflection of the wage-bargaining systems, which both in our estimated model and in real time operation tend to react more quickly to shocks. Historically, inflationary shocks have tended to be more persistent in Spain and Italy than elsewhere in Europe, and this still appears to be the case. Inflation is expected to be more than 1 percentage point higher this year in these three economies as a result of the oil price rise, while consumer prices in Germany, France and the UK are expected to rise by 0.6-0.7 per cent as a result.

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The short-term impact on output is also expected to be higher in the US than elsewhere. Output in the US is expected to be about 0.6 per cent lower this year as a result of the higher oil price, while output in the major European economies is expected to be 0.1-0.4 per cent weaker. Within Europe, the short-term impact on output is somewhat higher in Germany and France than elsewhere.

In the longer-term, we can expect the shift in the relative price of factor inputs to induce firms to shift towards more energy-efficient production processes and partially substitute oil input with other factors of production, such as labour and capital. We model the potential output of an economy through an underlying production function of the form:

Q = [gamma][[delta][K.sup.-[rho]] +(1-[delta])[([Le.sup.[lambda]t]).sup.-(1-- [alpha])/[rho]] [M.sup.[alpha]]

where Q is output, K is the capital stock, L is labour input, t is a labour augmenting technology measure and M is oil input. The parameter [gamma] captures neutral technical progress, while [delta] is a distribution parameter, [lambda] is the average rate of labour augmenting technical progress, [rho] is related to the elasticity of substitution between labour and capital ([sigma] = 1/(1+ [rho])) and [alpha] is the oil share of output in a base year. This framework imposes a unit elasticity of substitution between oil input and the labour-capital bundle, so that the share of oil costs in production is constant in the long run, although adjustment towards this long run in response to a price rise may be very protracted. The inner function imposes a CES relationship between capital and labour, with an elasticity of substitution between these two factors of production of about 0.5.

A shift in relative prices of oil and other factor inputs will lead to a decline in demand for oil as a factor input and a relative increase in demand for labour and capital. If the initial factor bundle was optimal this will lead to a decline in the productive potential of the economy and a permanent loss of output. The magnitude of the long-term impact on output is driven by the oil intensity of production, which is also given by [alpha] in our production function described above. Figure 5 plots our estimate of the long-run impact of the rise in the oil price on trend output, against the share of fossil fuels in the volume of output in 2010, as reported in table 1. In the long run, trend output in the US can be expected to decline by more than 1 per cent if the recent oil price rise proves permanent. The permanent output loss in Italy and Spain can also be expected to be close to 1 per cent, while trend output in Germany can be expected to have declined by about 0.8 per cent and the long-run impacts in the less oil intensive economies of the UK and France are smaller.

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The policy response to the oil price shock

In the medium term the impact of an oil price shock on prices will depend upon the behaviour of wage and price setters and the reaction of central banks, and in the longer term only on the latter. If in the past inflationary shocks have continued for some time, then there is a good chance they will be expected to do so this time. If, however, such shocks have been quickly absorbed in the past with inflation returning to normal, then there is a good chance they will be expected to do so this time. We might classify Italy and Spain as having in the past been in the former group, whereas Germany and the Netherlands in the past have been in the latter group. It is of course possible that people recognise that the world may change and that the ECB is a different animal from the Bank of Italy or the Bank of Spain, and hence they may not expect past experience to be repeated.

Many of the widely expressed fears of inflation and low growth following on from oil price increases come from experience of the oil shocks in 1974 and 1979. Oil was more important in the economy then and the first round effects were larger. Wage setting was also more backward looking, with indexation being common, as Anderton and Barrell (1995) discuss. More importantly, wage bargainers did not fully appreciate that an increase in oil prices would reduce the equilibrium real wage in the economy, as it involves a change in the terms of trade (2) as well as a reduction in the level of sustainable output. In the 1970s there was a strong attempt by labour unions and others to raise wages to maintain incomes, and the resulting unemployment could only be dealt with by expansionary monetary polices. Eventually real wage reductions took place, but only after a long 'game' between wage bargainers and the central banks. The Bundesbank was the most successful in this game, and the Bank of England probably the least successful. The increase in oil prices we consider in this note would require a reduction in real consumer wages (total compensation per person hour divided by the consumer expenditure deflator) of around 1 per cent in the UK, Germany and France and up to 2 per cent in the more oil intensive countries such as Italy, Spain and the US.

Monetary policy responses do matter after the first year, and we can group possible monetary responses into two sets--those that stabilise the inflation rate, and those that do this and also target a nominal magnitude such as the price level or nominal GDP. An inflation targeting regime, such as that described by a Taylor Rule, feeds back on deviations of inflation from target, and the effects of a shock to oil prices will depend on the strength of the feedback and also on the speed of response of the economy to the shock. If oil prices rise and a Taylor Rule is in place, then inflation will be above target for a sustained period, and will eventually come back to target. This happens in part because rational agents in the market know it will happen and act accordingly. If a nominal target is in place and rational agents know about this, then inflation will rise much less than it would under a Taylor rule. (3) The ECB has said for some time that it operates a two pillar strategy, with a nominal magnitude affecting its decisions, and the Federal Reserve has recently discussed including a similar concern in its strategy. In order to simplify our simulation analysis we apply the same rule in all countries.

We have run a number of experiments using our model NiGEM. In each case we assume financial markets are forward looking, and because inflation increases and central banks follow a policy rule and raise policy interest rates, long-term interest rates jump up and forward-looking exchange rates and equity markets adjust. We also assume tax rates change to keep governments solvent, and investment decisions are forward-looking and rational, and as the capital stock needs to be lower investment will slow down. We assume consumers are myopic but react to changes in their (forward-looking) financial market asset values. Our results are reported in table 3. In all but the last simulation we assume labour market bargainers look forward and are aware of the policy rule in place. In the first experiment we assume that an inflation and money stock targeting regime is in place, and inflation rises sharply in all countries, but after the first year it moderates and the increase averages 0.1 to 0.2 percentage points per annum in all countries over the subsequent five years. It settles back on base in the long run. The same happens in the long run with an industry standard Taylor Rule, and the impact effects are the same. However, in all countries inflation is noticeably higher for the five years following on from the shock, as the feedback rule is less aggressive toward price level overshoots and wage bargainers and financial markets know this. If we assume central banks target the price level in the long run, inflation subsides much more quickly in part because expectations keep it within bounds. In addition, under price level targeting the central bank is required to be more reactive as inflation overshooting must be offset by undershooting in order to restore the price level. In the long run inflation returns to the base (target) level in all scenarios.

Oil prices and QE2

The current situation in the US is of great interest because since our last forecast oil prices have risen and the Federal Reserve has launched a new round of Quantitative Easing (QE2). It is difficult, but not impossible, to gauge effects on the yield curve from these impulses. In order to assess the impact of monetary easing on the interest rate path in the US, we first factor out the impact of the higher oil price. We use the NiGEM simulation described above, with interest rates determined by a price level targeting rule as described in Barrell, Hall and Hurst (2006). This would raise inflation in the US by more than 1 percentage point in the first year, reduce output by 0.7 per cent and raise interest rates by 90 basis points relative to baseline in 2011. As inflation returns to base, target interest rates return to base levels by 2014. Our assumption of forward-looking financial markets means that these future interest rate changes are embedded in the current and future long rate.

The impact of QE2 is then estimated by looking at the difference between the path for short-term interest rates implied by the yield curves in October 2010 and January 2011, after factoring out the rise in interest rates associated with the oil price. This path is illustrated in figure 5, and suggests that the policy has effectively reduced interest rates by 100 basis points this year. While actual interest rates may be restrained by the zero lower bound, holding the interest path unchanged despite the rise in the oil price effectively acts as a monetary stimulus this year and next. In the longer term interest rates will be higher as a result of the short-term stimulus through QE2, as the medium-term prospects for inflation have increased, and this is reflected in the steepening of the yield curve since October.

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Conclusions

The steep rise in oil prices we have seen since October 2010 is likely to be sustained, and as such it will impact on trend growth and the rate of inflation in the medium term. There is little policymakers can do about the inflation and output effects in the first year as these follow on from the use of energy in production. Much the same can be said for the impacts of oil on trend output and sustainable consumption. Trend growth will fall for a few years, and the fall will be greater the more oil intensive the economy. The combination of lower output and a change in the terms of trade means that consumption in oil importing countries will have to fall, as will real wages. However, it is essential for the central bank to signal its position on worries about medium-term inflation. If the central bank only desires to return inflation to target, then it will be higher in subsequent years than if they plan to return prices to target. Such a desire could be signalled by a rise in interest rates early in the process of reaction. Strong central bank reactions cannot reduce the impact on growth, but they can reduce the impacts on inflation.

DOI: 10.1177/0027950111401136

REFERENCES

Anderton, R. and Barrell, R. (1995), 'The ERM and structural change in European labour markets: a study of 10 countries', Weltwirtschaftliches Archiv, Band 131, Heft I.

Barrell, R. and Dury, K. (2000), 'An evaluation of monetary targeting regimes', National Institute Economic Review, 174, October, pp. 105-13.

Barrell, R., Hall, S.G. and Hurst A.I.H. (2006), 'Evaluating policy feedback rules using the joint density function of a stochastic model', Economics Letters, 93 (1), October, pp. 1-5.

NOTES

(1) A storeable but exhaustible resource should see its price rise in line with the real interest rate, with the initial price being influenced by the backstop technology. Given this condition, which is known as Hotelling's rule, it should not surprise us that oil prices are higher now than 30 years ago. However, the path in between is rather surprising if theory were a useful guide.

(2) A given level of oil use in the OECD countries requires larger payments to OPEC when oil prices rise, and hence a given level of output can only be associated with a lower level of consumption in the OECD and higher consumption in OPEC.

(3) Barrell, Hall and Hurst (2006) and Barrell and Dury (2000) compare Taylor Rules and Nominal Targets, and demonstrate these (relatively obvious) points

Table 1. Volume share of fossil fuels in GDP

 Euro Area France Germany Italy Spain UK US

1975 6.20 5.37 7.86 4.91 3.95 6.73 12.31
1980 5.74 4.76 7.29 4.33 4.64 6.08 10.97
1985 4.96 3.57 6.57 3.85 4.08 5.31 8.88
1990 4.43 3.14 5.33 3.82 3.71 4.70 8.28
1995 4.13 2.93 4.52 3.73 3.96 4.29 7.84
2000 3.88 2.76 4.00 3.67 4.20 3.80 6.97
2005 3.80 2.57 3.83 3.72 4.32 3.41 6.27
2006 3.68 2.46 3.75 3.62 4.08 3.29 6.03
2007 3.53 2.39 3.48 3.52 4.06 3.13 6.04
2008 3.47 2.39 3.45 3.48 3.93 3.11 5.87
2009 3.41 2.35 3.39 3.36 3.67 3.01 5.67
2010 3.31 2.28 3.28 3.29 3.61 2.89 5.39
2011 3.18 2.18 3.13 3.21 3.55 2.72 5.15
2012 3.03 2.06 2.95 3.10 3.45 2.54 4.88

 China (a) India (b)

1975 16.25
1980 17.20
1985 17.76
1990 17.89
1995 18.39
2000 23.55 17.45
2005 24.66 15.71
2006 24.32 14.89
2007 23.18 14.72
2008 22.66 15.01
2009 22.63 15.21
2010 22.25 14.87
2011 22.08 14.34
2012 21.69 13.78

Notes: (a) Chinese fossil fuel usage valued at world prices, not
domestic market prices which are much lower. (b) There is a smaller
bias in the Indian figure.

Table 2. Value share of fossil fuels in GDP

 Euro Area France Germany Italy Spain UK US

1975 3.97 3.80 3.01 9.59 7.34 6.61 7.77
1980 8.48 6.83 7.50 12.40 13.06 9.57 16.35
1985 7.46 4.71 8.18 7.92 9.56 7.97 7.53
1990 2.58 1.65 2.76 2.63 2.83 3.06 4.91
1995 1.47 1.01 1.44 1.46 1.67 2.02 3.08
2000 3.06 2.16 3.00 2.98 3.66 2.72 4.12
2005 3.80 2.58 3.84 3.73 4.33 3.42 6.26
2006 4.38 2.92 4.53 4.31 4.76 3.87 7.15
2007 4.16 2.80 4.18 4.14 4.63 3.64 7.72
2008 5.04 3.43 5.15 5.01 5.51 5.09 9.98
2009 3.34 2.29 3.42 3.23 3.49 3.73 6.15
2010 4.36 2.99 4.45 4.23 4.61 4.53 7.42
2011 5.08 3.48 5.24 4.94 5.42 4.97 8.62
2012 5.26 3.62 5.43 5.14 5.68 5.01 8.78

 China (a) India (b)

1975 5.75
1980 13.01
1985 10.44
1990 8.09
1995 7.10
2000 14.56 11.44
2005 24.60 15.68
2006 27.99 17.85
2007 26.16 16.85
2008 29.82 22.44
2009 19.38 16.17
2010 23.29 16.97
2011 26.87 17.22
2012 28.08 16.90

Notes: (a) Chinese fossil fuel usage valued at world prices, not
domestic market prices which are much lower. (b) There is a smaller
bias in the Indian figure.

Table 3. Policy rules and inflation outcomes (percentage point
difference from base in annual inflation)

 Euro Area France Germany Italy Spain UK

Two pillar

Impact 0.81 0.73 0.63 1.07 1.22 0.69
Year 2-6 0.17 0.21 0.14 0.14 0.11 0.08

Taylor rule

Impact 0.79 0.73 0.63 0.97 1.15 0.67
Year 2-6 0.37 0.40 0.33 0.38 0.34 0.14

Price level

Impact 0.81 0.71 0.61 1.11 1.25 0.81
Year 2-6 0.00 0.06 -0.02 -0.06 -0.10 -0.04

 US

Two pillar

Impact 1.28
Year 2-6 0.16

Taylor rule

Impact 1.37
Year 2-6 0.66

Price level

Impact 1.16
Year 2-6 -0.11