Oil Widens the Atlantic Divide

Jens Erik Gould

December 17, 2014

http://www.thefinancialist.com/oil-widens-the-atlantic-divide/

Long before the price of West Texas Intermediate fell below $60 per barrel for the first time since 2009 on Friday, it became clear that the rout in oil markets would leave no corner of the global economy untouched. The further oil has dropped—there have been only three other occasions in the last four decades when it has fallen so far, so fast—the more investors have obsessed over the shock’s ultimate effects. One key area of debate is the impact on monetary policy. And for good reason—the ramifications of oil’s move are all in the eye of the beholder, with the decline in prices offering support to hawks in one place and doves in another. And it all revolves around a central question: is the oil price move going to have a larger impact on growth or inflation? For the U.S. and Europe, the answers appear to be very different indeed.

In the U.S., growth should win out, with the fall in oil prices more a boon to the economy than a drag on inflation. Cheaper gasoline will cut household energy costs as a portion of disposable income from an average of 3.2 percent at the start of 2014 to 2.2 percent in 2015, according to Credit Suisse. That effective multi-billion-dollar tax cut for consumers will dovetail with steady growth in jobs, a firming in wage growth and improving credit growth to drive retail sales higher and ultimately boost GDP growth, says James Sweeney, chief economist for Credit Suisse’s investment bank.

That’s not to say there are no disinflationary risks. Headline inflation, which was 1.5 percent in October, is on track to decelerate to 1 percent by the end of the first quarter of 2015 and to as low as 0.5 percent in the second. But it’s likely to then begin accelerating again, as oil price declines age out of the year-over-year calculations. In other words, the impending slowdown in headline inflation is likely to be a temporary phenomenon, says Dana Saporta, U.S. economics analyst at Credit Suisse. All things considered, then, the rout in the oil markets increases the probability that the Fed will raise rates sooner rather than later. “If anything, this oil decline has further strengthened our view that the Fed will be hiking in June of next year,” Sweeney says.

Across the Atlantic, it’s a different story. Cheaper fuel should also help boost consumer spending in Europe, but higher taxes on fuel will dampen the overall effect. European gasoline prices have fallen an average of just 8 percent since oil’s peak in June, compared with a 27 percent drop in the U.S., according to Bloomberg, in large part due the tax differential—tax on gasoline runs about $4 a gallon in Europe versus just 49 cents in the U.S..

That shifts the focus toward inflation, and Credit Suisse still expects the euro zone’s headline inflation rate to slip into negative territory next year. Annual headline inflation was 0.3 percent in November, a five-year low. At a December 4 press conference, European Central Bank president Mario Draghi emphasized the potential deflationary risks associated with the oil shock more than its possible impact on growth, and the central bank forecast that inflation will be 0.4 percentage points lower than originally expected in 2015.

Draghi is already on record with a goal to expand the ECB’s balance sheet by 1 trillion euros in a bid to boost lending. But he’s unlikely to reach that goal through the purchases of asset-backed securities and covered bonds he’s announced so far, and that underscores the need for a more aggressive QE program, according to Credit Suisse. “Draghi is not satisfied with the amount of stimulus provided so far,” Sweeney says. “He’s looking for excuses to do more and the falling oil price further enhances the chance that the ECB will ease.” That said, the bank will probably wait until March before making a move so it has time to assess the potential effects of falling oil prices on wage negotiations, according to Credit Suisse.

As we noted last week, monetary policy in the developed world in 2015 may be the most divergent it’s been since 1989, and the 40 percent drop in crude prices over the past six months is only exacerbating the differences. “Policy divergence is furthered by the oil price declines,” Sweeney says. “It makes the Fed more likely to hike and the ECB more likely to ease.”

Photo of Atlantic Ocean courtesy of underworld / Shutterstock.com 

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