With crude oil cutting the $60/bbl line and oil markets willing to test the pain threshold of the global economy, the financial markets are turning their eyes on ‘sick Europe’, on the assumption that the region might be the first shoe to drop. Since the impact of higher oil prices is neutral for the UK, whose oil trade balance is close to balance, the focus is on the euro area, where markets are now pricing a significant probability for a rate cut in the next six months. One point I often hear is that, this time, because Euroland is not protected by the ‘strong euro’ anymore, the harsher will be the pain. I disagree. Although models might be misleading when economic variables are sailing in uncharted waters, they are nevertheless helpful to assess the order of magnitude of various shocks, qualitatively at least.
Most empirical studies indicate that a 10% depreciation of the euro has a positive impact on GDP growth that far outstrips the negative impact of a 10% rise in crude oil prices. For instance, simulations performed by the OECD, using the multi-country model Interlink, suggest that the former would add 0.6% to GDP in the first year while the latter would subtract 0.1% over the same period. In other words, it would take a 60% rise in crude oil price to offset a 10% depreciation of the currency. None of these shocks has a lasting impact on GDP, as relative prices adjust in the medium to long term, yet, the short-term dynamics are critical for the markets and for policy makers.
True, the two shocks are of very different magnitude. Since the beginning of the year, crude oil priced in euros has risen by 60%, while the euro has lost 7.1%, on a trade-weighted basis. Then, taken at face value these numbers would suggest a slightly negative impact on GDP growth in the coming two to three quarters. Yet, since these external shocks feed through European economies only progressively, it is necessary to take on board past changes as well as current ones in order to have an idea of the full macro picture. To do that, we find it convenient to use the quarterly multipliers of the Insee model MZE-2003, which was estimated for the euro area taken as a bloc, because they give an idea of the short-term dynamics shaping the system.
We find that the combined effects on GDP of the euro and oil prices since the beginning of 2004 are clearly negative: -0.2% in 2004, and -0.25% in 2005. However, this holds for average growth numbers, which are highly sensitive to entry points. What is the most relevant for the financial markets is that, as far as 2005 is concerned, the bad news is largely water under the bridge, since most of the pain was inflicted to the real economy in the last two quarters. In fact, the positive effects of a weaker euro should start to over-run the negative impact of expensive oil prices in the remainder of this year. We do not want to take these simulations at face value. Nevertheless, they are consistent with the business surveys and, on a qualitative ground at least, they suggest that, GDP growth should accelerate somewhat in the coming two or three quarters, if the barrel of Brent remained in the vicinity of $55 (June average) and the euro around 100 on a trade weighed basis (Q1 1999 = 100), which would be consistent with 1.20 against the US dollar.
While the combined impact of these changes on the real economy are debatable, one thing is sure: a weaker euro and higher oil prices will push headline inflation higher. Not a serious cause for concern for the ECB as long as core inflation behaves as it has so far, but certainly not a reason to ease monetary policy, at this stage. Unless next week’s business surveys bring very bad news on the real economy, do not hold your breath expecting an imminent rate cut in Frankfurt. The ECB’s models are probably coming to conclusions not very different from what you have just read.
By Eric Chaney, Morgan Stanley Economist, in The Global Economic Forum