How do falling oil and commodity prices affect the world economy?

A feature of the latter part of 2014 has been the decline in both oil and commodity prices which has seen the world economy impacted by disinflationary winds of change. For example the Commodity Research Bureau Index peaked at 505 in early May and is now at 452 for a decline of 10.5%. A recent driving factor in this has been the 9% fall in the metals sub-index since the beginning of August and as we have discussed before on here the main player has been this below. From the Financial Review.

Iron ore out of the port of Qingdao in China slumped 4.4 per cent to $US71.80 a tonne, taking its total decline for the year to more than 46 per cent as oversupply and ongoing concerns over China’s economy continue to put pressure on the commodity.

This poses all sorts of distributional questions on its own especially for the South China Territories (Australia). That is reinforced by the fact that the HSBC Purchasing Managers Index for China came in at 50 or unchanged this morning. This reinforces the theme of a slowing Chinese economy.

The price of oil

This has been on a weaker path since the 19th of June when the Brent Crude Oil benchmark reached US $115.71 per barrel. Whereas this morning we find that it has gone as low as US $77.91 per barrel for a drop of 33%. This has been quite a sea change as past surges were replaced by a period where a Star Trek style tractor beam held the price around US $108 and now we have seen quite a fall. Obviously the theories surrounding Peak Oil have taken quite a pounding from this although one day no doubt they will be back.

There is an OPEC meeting on the 27th of this month but so far it has been rather supine in the face of these falls.

The media and modern conventional analysis hate this

I am going to look at some new thoughts from the Cleveland Federal Reserve on the economic impact but the quote below highlights the current official theme.

there is some concern that low oil prices, which have continued to remain below $90 a barrel through October, will keep inflation persistently below or even push it further from targeted levels.

You may note that rather than welcoming lower oil prices they have “concern” that inflation will go further below its target. They could not be clearer that their interests diverge from ours. I would make them and their media lackeys go to the nearest petrol/gas outlet and pay more! After all it is a good idea isn’t it?

However lower prices can be combined with good news as well as being good news themselves as today’s UK retail sales release has shown.

Average store prices fell by 1.5% in October 2014 compared with October 2013, this was the largest fall since December 2002 when prices also fell by 1.5%.

Continuing a sustained period of year-on-year growth, in October 2014, the quantity bought in the retail industry increased by 4.3% compared with October 2013,

Falling prices leading to higher volumes as disinflation is combined with a type of reflation?! Yes and you have my permission to put a clown’s hat on anyone who calls this deflation today. Or perhaps they should Bart Simpson style have to be writing “I must not call disinflation deflation” on the blackboard,say one thousand times.

What does the Cleveland Federal Reserve tell us?

The most direct impact that low oil prices, both domestic and international, have on other domestic prices is through a decline in retail gasoline prices.  While oil prices and gasoline prices follow the same trend, gasoline prices react with a delay to changes in oil prices. Gasoline prices have been trending around $3.50 a gallon for a few years, a level much higher than before the recession, but by the end of October, they had declined to $3.14 a gallon.

The Energy Information Agency now has US gasoline prices at US $2.98 per gallon. Also the drop has been larger than the Cleveland Fed would have you think as the price of gas averaged US $3.77 in June. Read that and weep UK readers as we pay some 2.43 times more if this week’s official figures are accurate. Perhaps the Cleveland Fed should buy its petrol/gas over here?

As an aside the US always mentions gasoline prices, is the diesel market very small?

What is the impact of this?

The authors of the Cleveland Fed paper seem desperate to avoid any favourable impacts from a falling oil price but even they tell us this.

The year-over-year percent change in the PPI for finished goods has been loosely related to international oil prices for the past 20 years. But when oil reached $60 a barrel in 2007, the two price series began to move more in sync. The year-over-year percent change in the PPI was lower in the most recent data release,

Ah so the effect has got stronger! Also the effect will be felt in other inflation indices.

Since the CPI is most directly influenced by oil price changes through its energy component, one question that remains is whether or not other components in the CPI are influenced by low oil prices…….A quick look at the year-over-year percent changes in the energy CPI and the CPI excluding energy suggests changes in energy prices are often followed by similar changes in the rest of the CPI’s components.

In fact apart from central bankers and their lackeys all of us will welcome such developments but predictably this paper does not.

The recent decline in oil prices is of less concern to many CPI forecasters, because it may not affect the “core” price level.  It would be a bit more concerning, however, if low oil prices also affected other domestic prices as well.

But Shaun you have told us this will give an economic boost?

You might think that the Cleveland Fed would highlight this is a report on the impact of a falling oil price would you not? Well I will leave readers to decide for themselves why such an important matter merits only part of one sentence.

However, as consumers use savings from lower energy prices for other goods and services,

So the hard-pressed consumer is able to spend more on other things as disinflation morphs into reflation (increased aggregate demand) one more time? Although the Cleveland Fed cheerily hopes that this impact will fade.

these prices are likely to rise in response, offsetting the initial disinflationary impact of lower oil prices.

Hooray! Hooray! Oh wait a minute……


Back on the 4th of this month I pointed out that there are a multitude of effects from falling oil and commodity prices. The net losers are places such as OPEC and Australia. The winners are the importing nations who not only get lower inflation but they get a host of reflationary impacts on their economies as import costs fall and demand is boosted. In other words they gain which is translated by the Cleveland Fed into “concern”.

It is very 1984 is it not where what we have previously been told is good for us is apparently now bad for us? Of course Pink Floyd did discuss this issue on the aptly named Dark Side of the Moon.

Us and Them
And after all we’re only ordinary men
Me, and you
God only knows it’s not what we would choose to do
Forward he cried from the rear
and the front rank died
And the General sat, as the lines on the map
moved from side to side
Black and Blue
And who knows which is which and who is who
Up and Down
And in the end it’s only round and round and round

What is the first casualty of an (economic) war? It is the truth I am sorry to have to tell you. Also let me add one more awkward fact which is that countries such as Japan which are pursuing a currency war objective of a lower exchange rate (118 and counting versus the US Dollar) are eroding some of the benefits of lower commodity and oil prices


18 thoughts on “How do falling oil and commodity prices affect the world economy?

  1. Shaun,
    Dare I suspect time to reintroduce a fuel tax increase in the UK ( that was postponed) in order to improve the “environment” and also help HMG coffers when ( poor/self employed) self assessment tax revenues fail to materialise?
    Does fuel duty with VAT then added count as institutionalised inflation and reduce price linkage to the actual cost/price fall of the raw material?

    • Hi Chris

      I put your suggestion out on twitter and I think that if this happens it is likely to be a post-election move as part of an austerity package I think. As to your second question the simple answer is yes. As it is we see that the actual oil component of the petrol/diesel price in the UK is small and whenever I tell people of the tax component there are more than a few who are surprised.

  2. Thank you for your commentary on this very interesting American paper, Shaun. I find it interesting that it devotes more attention to the impact of declining oil prices on the CPI than the personal consumption expenditure (PCE) deflator, although the latter is ostensibly the Fed’s target inflation indicator. Is there something wrong with the colours on their graph. I gather that the green line that end up second from the bottom for the nowcast for November 2011 is supposed to be the PCE deflator, but it is a green line (on my screen anyway) and the legend shows that it is supposed to be dark blue. The declining gas prices seem to have a bigger impact on the CPI than the PCE deflator.

    • Hi Andrew

      I had not thought of it like that but you are entirely correct. There should be a section explaining that they have used the CPI because it is more widely followed but that the Fed actually targets the PCE deflator. Indeed you could argue that this section is rather misleading.

      “At the same time, the year-over-year percent change in the most widely known measure of inflation, the Consumer Price Index (CPI), came in at 1.7 percent for September, which is below policymakers’ targeted levels.”

      I have asked them about this and will let you know should I get a reply.

  3. The recent sterling weakness will presumably have eroded some of the benefits the UK receives from cheaper oil too.

    I wonder if you or any economic historians can shed light on how much the global economic recovery of the 1980’s was attributable to the massive and sustained decline in crude oil prices during that era. Did the UK economy recover despite rather than as a result of Howe’s 1981 budget as a result of declining oil prices? Or did the recession of the early 1980’s lead to the collapse in oil prices which in turn triggered the global recovery?

    Will this fall in oil prices be sustained and serve as a massive global stimulus except to Russia, Venezuela and the Middle East?

    On a personal note, I’m pleased to report as a huge user of heating oil that the price of a 1000 litres just purchased was around 18% lower than at the same time last year. Given that the only duty/tax on our heating oil is 5%VAT, this seems to broadly reflect the reduction in the price of crude combined with the fall in sterling once an allowance for distribution costs is made.

    • Hi GO Paul

      Just under a third of the gains from a lower oil price have been lost due to the recent phase of UK Pound £ weakness. As to your question about 1980s oil prices I think that you have a point although recent econometric data/research has in my opinion only succeeded in confusing itself. Yes it will have boosted growth and lowered inflation although back in the heady days of the North Sea Oil boom there would have been a secondary contraction from that. Also don’t forget that this was pretty much the peak in the bond yield/interest-rate cycle for the UK and since then that has also boosted the economy. Unfortunately we have pretty much used that up.

      Good luck with the price of your heating oil which shows how much tax is on other oil products doesn’t it?

      As to your sustained question I am increasingly wondering if the previous rally was driven by the now defunct banks commodities operations in which instance there is a chance of oil prices staying low for a bit.

  4. hallo shaun,

    considering the lack of shame of these dogs I suspect that they’ll contemplating putting food and fuel back into “core” inflation as they are falling !!

    I too am waiting for the fuel escalator to be re-introduced – those falling revenues must be hurting !!

    If the trend is long term , in my terms that 18-24 months , then they can end up in cheaper ipads and food . but not much . Think of how high they have been and as I’ve said before is $80 oil cheap ?

    I suspect more a lack of demand because you can only fiddle hookers and skunk so long into the figures before reality comes back and bites you !

    Theres still clouds on the horizon – contraction beckons


    • Hi Forbin

      I do not disagree that weak demand is a factor in these falling prices but left to its own devices there is also an element of a repair mechanism. In these times of central bank interference they are more likely to mess with the repair mechanism than the damage which is currently being exhibited by the BoJ with the Yen drop.

      As to the long-term you are far better than our political class for whom it reaches to about 3:30 am tomorrow when the Rochester by-election results are expected!

  5. Hi Shaun
    Suffering from jet lag but caught up with your latest excellent pieces.
    From yesterday’s piece, I was wondering how much easier it will be to make capital controls work with such a reduction in international flows, after NIRP its only one step more….
    US gets friendlier with Iran and the Saudis drive down the oil price to hurt the frackers, who will blink first?
    These low oil prices are bringing out the ‘alternative energy’ nutters in droves. According to them low prices will decimate oil companies who need high prices to fund increasingly expensive developments. Apparently supply and demand are side-lined.
    Times going to get tougher in the ‘SCA’, Glencore ( Marc Rich in my days) stops production for a week at its mines. Back to sheep and tourists…
    Smiles back on faces in the US when gas drops below $3. Everything is affected, transport plays a big part in costs over a huge interconnected country. But they do need rain in California otherwise a lot of food prices will not fall.

    • Hi JW and thanks

      As to capital controls I have noticed a discernable trend in the credit crunch era in the economic literature to if I may put it this way “diss” the role and impact of saving and savers. On that road actual cuts to deposits like the ones in Cyprus almost seem reasonable at least to them. Very marxist in its way and of course they would require some form of capital controls or the funds would simply flee.

      Is the recent strength of the Swiss Franc a sign of people’s fears about this?

      Perhaps Albert Hammond was right with this part of his lyric.

      “Seems it never rains in southern California”

  6. Hi Shaun,
    It’s the beginning of the old fashioned cycle in my text books of ’77 isn’t it?

    Low energy price = falling prices = increase in consumption = increase in GDP = increasing oil prices = increasing prices = decrease in consumption = decrease in GDP and the cycle completes. At least the Cleveland Fed covered part of the cycle, but it seems like things are changing back to how the textbooks say they are, and it feels good.

  7. Hi Shaun,

    Where increasing oil prices were largely counter cyclic and turned into a double whammy with the talked down pound, which IMO must have deepened our 6 year economic depression. So now we are getting boost on the upside from falling oil prices, tempered by a surging USD, then the doom merchants seem to be out in force again.

    Personally, after several years of above target ‘temporary’ inflation, what is wrong with under-target or disinflation, which boosts our spending power? All goods have an energy component including food where the EROEI is about 10:1 against! So we should see reductions or smaller increases as a result.

    This country has suffered along with the EU with their scarce expensive energy policies that are driving or have driven many high energy industries away from Europe to the US. So although these reductions are welcome, much more needs to be done on making our energy prices more competitive which means we need to get fracking.

    • Hi Rods

      You are correct to point out that we seem to be told that a higher oil price is bad for us and now a lower one if too! Actually as Forbin points out it isn’t even that low. Personally I welcome the lower oil prices which also may help the Euro area for example, I had a wry smile that this was ignored when today’s poor PMI numbers were released.

      As to high price for fuel for industry in Europe well Ineos took the initiative today.

      “Dwindling supplies of ethane gas from the North Sea has threatened the competitiveness of INEOS manufacturing units in Grangemouth (Scotland) and Rafnes (Norway). In addition, across Europe, spiralling energy costs continue to threaten the very future of its petrochemical industry. The issue is widely acknowledged by those manufacturing businesses trying to compete in global markets. But as many wait for a political solution, INEOS is taking action, now, to protect its business before it is too late. From next year it will start shipping competitively-priced ethane from US shale gas to its gas crackers in Europe. Now it is looking longer term and is seeking to access indigenous gas from UK shale. Hydraulic fracturing has led to a manufacturing renaissance in America. It could do the same for the UK and Europe.”

  8. Hi Shaun,.
    The number of outlets for the truth seem to be declining fast. In the past it seemed fairly easy to recognise “spin” – it was the stuff emanating from spin doctors. It was almost always political.

    However, spin has now been transformed into misleading information and is all-pervasive. The truth is now a casualty in the output of official documents and reports covering all aspects of business and economic life – And, worse still, it’s “re-tweeted” by the mainstream media!
    Are TPTB really that desperate to hang on to power.

    Thankfully there’s a place I know that maintains a straightforward, balanced and accurate perspective – right here. Thanks.

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