Oil prices have been falling in recent months. By early June they had reached a 17-month low. The benchmark US crude price (the West Texas Intermediate price) fell to $83.2 at the beginning of the month, and Brent Crude (the North Sea reference price for refining into petrol) fell to $97.7 (see chart). (For a PowerPoint of the chart below, click here.)
At the same time various commodity prices have also been falling. The IMF all commodities price index has fallen by 7.2% over the past 12 months and by 6.2% in May alone. Some commodities have fallen much faster. In the 12 months to May 2012, natural gas fell by 44%, wheat by 25%, lamb by 37%, Arabica coffee by 36%, coconut oil by 45%, cotton by 47%, iron ore by 23% and tin by 29%.
Although part of the reason for the fall in the price of some commodities is increased supply, the main reason is weak world demand. And with continuing problems in the eurozone and a slowdown in China and the USA, commodity price weakness is likely to continue.
So is this good news? To the extent that commodity prices feed through into consumer prices and impact on the rate of inflation, then this is good news. As inflation falls, so central banks will be encouraged to make further cuts in interest rates (in the cases where they are not already at a minimum). For example, the Reserve Bank of Australia cut its cash rate last week from 3.75% to 3.5%. This follows on from a cut from 4.25% on 1 May. In cases where there is no further scope for interest rate cuts (e.g. the US Federal Reserve Bank, whose interest rate is between 0% and 0.25%), then the fall in inflation may encourage a further round of quantitative easing.
But falling commodity prices are also a reflection of bad news, namely the low economic growth of the world economy and fears of turmoil from a possible Greek exit from the euro.
Update
A day after this was written (9/6/12), a deal was agreed between eurozone ministers to provide support of up to €100 billion for Spanish banks. This helped to reduce pessimism about the world economy, at least temporarily. Stock markets rose and so too did oil prices, by around 1%. But if pessimism increases again, then the fall is likely to resume.
Articles
Oil prices hit a 17-month low on China slowdown fears BBC News (8/6/12)
Oil gives up gains without signs of Fed move BloombergBusinessweek, Sandy Shore (7/6/12)
Oil Heads for Longest Run of Weekly Losses in More Than 13 Years BloombergBusinessweek, (8/6/12)
Gold plunges as Bernanke gives no hint of stimulus Live5News(7/6/12)
Oil Price Tumbles Below $83 on Weak Economy Money News(8/6/12)
World food price index expected to fall for May Reuters(6/6/12)
Oil price losing streak continues Guardian, Julia Kollewe (8/6/12)
Data
Spot fuel prices US Energy Information Administration
Commodity Prices Index Mundi
Crude Oil Price Index Index Mundi
Questions
- Why have crude oil prices fallen to their lowest level for 17 months?
- How can the concepts of income elasticity of demand, price elasticity of supply and price elasticity of demand help to explain the magnitude of the fall in crude oil prices?
- Would a fall in inflation linked to a fall in commodity prices be a fall in cost-push or demand-pull inflation? Explain.
- What are the macroeconomic implications of the fall in crude oil prices?
- What factors are likely to have significant impact on crude oil prices in the coming months
- Why is it difficult to predict crude oil prices over the coming months?
For some, thoughts will have turned to events on football pitches in South Africa. Perhaps though we should spare a thought for the Governor of the Bank of England, Mervyn King, who is likely to be concerned by his own team’s recent performance in missing the inflation rate target! Mervyn’s resulting ‘yellow card’ involves writing a letter to the Chancellor of the Exchequer every time the annual rate of CPI (Consumer Price Index) inflation deviates by more than one percentage point from the government’s central target of 2%. Unfortunately for the Governor, since the turn of the year, only in February has the annual rate of CPI inflation failed to exceed 3%. And, even that was within in a whisker of missing the goal since the rate of inflation squeaked in at 3%. Perhaps February was more a case of hitting the post!
As all sports fans know, a run of disappointing results can lead to dissent amongst players and supporters alike. We can see from the minutes of June’s meeting of the Monetary Policy Committee the extent of the debate over the persistence of inflation. The debate included discussions concerning the impact of the expected fiscal consolidation measures (the MPC met before the Budget), the public’s higher inflation rate expectations, the price of oil and other commodities and the margin of spare capacity in the economy (the output gap). The minutes reveal that one member of the MPC, Andrew Sentance, voted for an increase in interest rates believing that inflation had been particularly resilient in the aftermath of the recession.
We now have new forecaster in town: The Office of Budget Responsibility. In our blog article Who’d be a forecaster? A taxing time for the new OBR we looked at the growth forecasts produced by the Office of Budget Responsibility taking into account the Budget Measures of 22 June. The June 2010 OBR Budget forecasts also contain predictions for CPI inflation. So what do the OBR say?
The OBR predicts that the annual rate of CPI inflation will stay around 3% in the near term. It is now slightly more pessimistic about the prospects for inflation beyond the near term than it was in its pre-Budget forecasts. More specifically, it says that CPI inflation will ‘decline more gradually’ than first thought because of the rise in the standard rate of VAT to 20% in January 2001 and its belief that oil prices will be higher than originally envisaged. The OBR is forecasting the average price of a barrel of oil in 2010/11 to be $78 rising to $82 in 2011/12.
Going further ahead, the OBR expects the rate of inflation to fall back to ‘a little under 2 per cent in early 2012’. It argues that this will reflect the unwinding of the VAT effect, and, significantly, the downward pressure on prices from the larger negative output gap that will result from the fiscal consolidation measures in the Budget. In other words, the expectation is that there will be greater slack or spare capacity in the economy which will help to subdue price pressures.
If the OBR is right, the Governor may have more letter-writing to do in the near term and perhaps well into 2011. But, the fiscal consolidation measures should, once the impact of the VAT rise on the inflation figures ‘drops out’, see the rate of inflation fall back. Perhaps then, the final whistle can be blown on the Governor’s inflation troubles. In the mean time it will be interesting to see how MPC members take on board, in their deliberations over interest rates, the Budget measures and the OBR’s own thoughts on inflation. Could interest rates be rising shortly despite fiscal consolidation? Let Mervyn and his team play on!
OBR Forecasts
Budget Forecast June 2010 OBR (22/6/10)
Pre-Budget Forecast June 2010 OBR (14/6/10)
Monetary Policy Committee
Overview of the Monetary Policy Committee
Monetary Policy Committee Minutes
Inflation Data
Latest on inflation Office for National Statistics (15/6/10)
Consumer Price Indices, Statistical Bulletin, May 2010 Office for National Statistics (15/6/10)
Consumer Price Indices, Time Series Data Office for National Statistics
For CPI (Harmonised Index of Consumer Prices) data for EU countries, see:
HICP European Central Bank
Articles
MPC minutes reveal Bank split on inflation risk Financial Times, Daniel Pimlott (23/6/10)
Bank of England minutes reveal surprise split on interest rates Guardian, Katie Allen (23/6/10)
Instant view: Bank split 7-1 on June vote Reuters UK (23/6/10)
Now even the Bank isn’t sure it can bring down inflation Independent, Sean O’Grady (24/6/10)
An inflation hawk hovers over the Bank of England Guardian, Nils Pratley (24/6/10)
Questions
- Explain why an output gap – the amount of spare capacity in the economy – might impact on price pressures.
- What impact would you expect the rise in the standard rate of VAT next January to have on the CPI (price level) and on the CPI inflation rate? What about the following year?
- Some economists believe that by being more aggressive in cutting the fiscal deficit, interest rates will be lower than they otherwise would have been. Evaluate this argument.
- Now for your turn to be a member of the MPC and to decide on interest rates! How would you vote next month? Are you a ‘dove’ or a ‘hawk’?
Oil prices have been falling in recent months. By early June they had reached a 17-month low. The benchmark US crude price (the West Texas Intermediate price) fell to $83.2 at the beginning of the month, and Brent Crude (the North Sea reference price for refining into petrol) fell to $97.7 (see chart). (For a PowerPoint of the chart below, click here.)