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Economics Economics – Markets – Strategy Global growth survived the rise in oil prices because it drove the rise in oil prices Inflation presents a serious problem to central bankers everywhere. But more so in the G3 than in Asia Will Asia immiserize the G3? Where does all this leave us? We have noted that disaster planners could not have invented a more hellish scenario for Asia than the current reality. US demand growth has fallen to zero over a three year period and oil prices have tripled over the same three years (and risen fivefold in five years). Yet rather than collapsing, Asia continues to grow better than it should even on a clear day. We have argued that demand – Asian demand mostly – explains both of these puzzles. Asian final demand kept Asia on an acceleration path for 3 years while the US slowed. And demand, not supply, appears quite compellingly to be the driving force behind the fivefold increase in oil prices that occurred over the past five years. Moreover, the data clearly show that Asia accounts for the lion’s share of the growth in worldwide oil consumption since 2001. Indeed China and India alone accounted for almost two-thirds of the global growth in oil consumption between 2005 and 2006. And while a portion of this was undoubtedly intermediate demand, the growth in Asia’s aggregate final demand – that which kept Asia accelerating for three years while the US slowed – suggests that Asia’s demand for oil was, likewise, made in Asia. In short, global and especially Asian growth ‘survived’ the rise in oil prices because it drove the rise in oil prices. An important corollary is that, unlike when prices surge due to a contraction in supply, there is no hammer waiting to fall on economic growth. It has already dropped, bit by bit. Higher oil prices are a burden but when driven by an expansion in demand it is shouldered in real time – two steps forward, one step back. Two steps forward, one step back. And efficiency gains over the decades have helped make the backward steps smaller. Perhaps all this sounds too good to be true. New world this, new order that. Everything’s paid for, nothing to worry about. The hypothetical disaster scenario became a reality and guess what? Growth accelerated to above potential rates and it’s still there. We met the first enemy. We outgrew him. We met the second enemy. It is us. Things are fine. Well....not completely. Inflation is on the rise and that presents a problem for many a central bank, not just, and probably not mainly, in Asia. In Asia, food has been the key driver of inflation over the past year but ex-food inflation is accelerating now too and will soon jump much more noticeably in countries like Indonesia, Malaysia and India, where oil-related subsidies have been cut sharply in recent weeks. They had become too expensive for governments to maintain. Inflation is rising in the US and Europe too, thanks mainly to higher oil prices. Eurozone (HICP) inflation has risen to 3.6% YoY, the highest since June 1992. US CPI inflation has risen to 4% YoY, the highest since July 1991, save for two short spikes (also oil related) in Sep05 and June06. With the latest surge in oil prices (Brent crude is up by 45% since the start of the year in USD terms) inflation is undoubtedly headed higher in the near term and central bankers on both sides of the Atlantic are already making noises about rate hikes. If you take the view that higher oil prices are due to temporary supply disruptions, then hiking interest rates is probably not first-best policy, especially in the US where domestic demand growth is already at ground-zero. Inflation would, on 18
Economics – Markets – Strategy Economics this view, fall back pretty quickly with or without rate hikes. So the good news is, few would be required / delivered and the consequences for growth would be minor. But if you take the view, as we have, that higher oil prices are being driven by expanding demand, then the policy prescription and the prognosis for growth changes. A greater number of interest rate hikes would be required to tame inflation. A greater hit to growth would result. How much growth a country has to sacrifice would depend on its preferences toward inflation. In Asia, inflation of 4%-8% has been the norm and the consequences to growth of maintaining that sort of rate are probably minor. After all, ex-food inflation in Asia is still running at only its 20-year average rate, even after a fivefold increase in oil prices since 2003. Yes, it will no doubt rise a little above the 20- year average in the coming year but that happens, by definition, exactly half the time anyway. Getting back to average in Asia will be a comparatively easy and low-cost exercise. Compared to what? Compared to the US and Europe. Their preferences toward inflation run on the order of 2%, not 4% to 8%. If they want to get inflation down to 2%, they will surely have to sacrifice considerably more in the way of growth. Why? Because, oil prices are no longer Made in America, or in Europe. They are made in Asia. Europe, Japan and the US all cut their oil consumption over the past two years. Europe and Japan have been cutting it every year for a decade. That hasn’t cut global demand. Or prevented oil prices from quintupling. Or prevented US and European inflation from going up. US and European central banks could raise interest rates and that would probably lower aggregate demand in the US and Europe. GDP growth too. Alas, unless the G3 went truly into recession, it would do little to curb Asia’s demand for oil. So we seem to have entered yet another brave new world. A lot of that going around lately. Asia is driving things – important things like the price of oil, its own rate of GDP growth and, increasingly, aggregate global demand growth as well. Given these structural changes, is it really any surprise that it would begin to dominate global inflation rates either? G3 central banks and politicians in particular may not wish to accept an inflation rate determined by Asian preferences. But to the extent they attempt to fight it, they would only lower their (own) economic growth. Eventually of course they would capitulate. How much growth they sacrifice on an unwinable war is anyone’s guess. But the ECB and the Fed are either “new” or under new leadership, or both, so the fight could be an ugly one. Perhaps it’s not such a clear day after all. Oil prices are driving inflation. But oil prices are not made in America or in Europe. They are made in Asia G3 central banks may have to accept an inflation rate made in Asia too. That or a permanently lower growth rate 19
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