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Macroeconomic implications of the recent oil price decline

Raju Huidrom's picture
Following four years of relative stability at around $105 per barrel (bbl), oil prices have declined sharply since June 2014. It is not the first sharp oil price swing: there have been five other episodes of oil price drops in excess of 30 percent and several more episodes of oil price spikes. Over the past five decades, these steep drops and spikes have stimulated an extensive literature on the macroeconomic implications of oil price swings and the channels through which they operate. A recent Policy Research Note by the World Bank reviews this literature.
 
Key Channels
 
Falling oil prices often affect activity and inflation by shifting aggregate demand and supply and triggering policy responses. On the supply side, lower oil prices lead to a decline in the cost of production. The lower cost of production across a whole range of energy-intensive goods may be passed on to consumers and hence, indirectly, reduces inflation. The lower cost of production can also translate in higher investment. On the demand side, by reducing energy bills, a decline in oil prices raises consumers’ real income and leads to an increase in consumption.
 
The effects depend on policy responses, such as monetary and fiscal policy. If falling oil prices ease inflation – especially core inflation or expectations – central banks may respond with monetary loosening which, in turn, can boost activity. However, if core inflation or inflation expectations do not ease with falling oil prices, central banks may refrain from a monetary policy response such that the impact on real activity could be small. With regard to fiscal policy, revenue losses associated with a drop in oil prices can constrain fiscal policy in oil exporting countries which can then adversely affect output.
 
Abrupt changes in oil prices, by increasing uncertainty, can also reduce investment and durable goods consumption. To the extent that the return from an irreversible physical investment project depends on the price of oil, increased uncertainty about the future price of oil could cause firms to delay investment and reduce capital expenditures. Following a similar mechanism, uncertainty associated with sharp movements in oil prices can also hinder consumption of durable goods.
 
Impact on activity
 
For the global economy as a whole, a supply-driven 45 percent oil price decline (as expected, on an annual average basis, between 2014 and 2015) could be associated with an increase in world GDP of about 0.7-0.8 percent in the medium-term. Most of the literature focuses on estimating the impact of oil price increases on real activity in major economies. These estimates vary widely, depending on the oil intensity of the economy, oil exporter/importer status, data samples, and methodology. For example, for OECD countries, a 10 percent increase in oil prices has been associated with a decline in real activity of 0.3-0.6 percent in the United States and 0.1-0.3 percent for the Euro Area. Studies for developing countries have reported a wide range of findings.
 
The recent literature has established that the effects of oil prices on activity and inflation depend on the underlying source and direction of the changes in prices. Also, the impact has declined over time.
 
Source of the oil price movements. The impact of oil prices on activity depends critically on their source. Oil supply shocks would be expected to generate an independent impact on activity. In contrast, oil demand shocks would themselves be the outcome of changing real activity with limited second-round effects. Indeed, oil price changes driven by oil supply shocks are often associated with significant changes in global output and income shifts between oil exporters and importers. Changes in prices driven by demand shocks, on the other hand, tend to lead to weaker and, in some studies, insignificant effects.
 
Asymmetric effects. The failure of the 1986 oil price collapse to produce an economic boom has sparked a literature on the asymmetric impact of oil price movements on activity. Such an asymmetric effect may result from costly factor reallocation, uncertainty, and an asymmetric monetary policy response. In particular, the U.S. Federal Reserve has typically chosen to respond vigorously to inflation increases triggered by higher oil prices but has responded less to unexpected declines in inflation following oil price declines. While oil price increases – especially large ones – have been followed by significantly lower output in the United States, some studies report that oil price declines have been associated with much smaller, and statistically insignificant, benefits to activity.
 
Declining energy intensity. Several studies have documented that the impact of oil prices on output has fallen over time. For example, Hamilton (2005) estimates that a 10 percent oil price spike would reduce U.S. output by almost 3 percent below the baseline over four quarters in 1949-80 but less than 1 percent in a sample that extends to 2005. The literature has offered a variety of reasons for the declining impact of oil prices on the economy: structural changes such as falling energy-intensity of activity, and more flexible labor markets which lowered rigidities associated with price-markups. In addition, stronger monetary policy frameworks have reduced the impact of oil price shocks by better anchoring inflation expectations, thus dampening firm pricing power and helping create a regime where inflation is less sensitive to price shocks.
 
Such effects differ across countries: benefiting oil importers but harming oil exporters. The expected positive impact of an oil price decline on the global economy reflects the benefits from lower oil prices for some of its largest economies.
 
Impact on Inflation
 
Historically, oil price swings and inflation have been positively correlated, even though this relationship has varied widely across countries. Large increases in oil prices during the past 40 years were often followed by episodes of high inflation in many countries. As in the case of output, the impact of oil price swings on inflation has, however, declined over the years. For instance, Hooker (2002) showed that oil prices contributed substantially to U.S. inflation before 1981, but since that time the pass-through has been much smaller. Similar results have been found for other advanced economies and for some emerging market economies. The decline in pass-through is attributable to the reasons above that explain the decline in the impact on activity, in particular improvements in monetary policy frameworks that resulted in better anchoring of long-run inflation expectations.
 
Conclusion
 
The recent decline in oil prices will have significant macroeconomic implications. If sustained, it will support global growth and disinflation. It will also trigger significant real income shifts from oil exporters to oil importers, strengthening growth and reducing inflation in a large number of oil- importing countries but dampening economic activity in oil-exporting countries.
 
This post is based on the recently launched World Bank Policy Research Note titled The Great Plunge in Oil Prices: Causes, Consequences, and Policy Responses’. The Note builds on the analysis of oil markets, published in the January 2015 editions of the World Bank’s Global Economic Prospects and Commodity Markets Outlook.
 

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