The next big economic shock is just around the corner

Telegraph

5 hours ago

For every unit of output, the world economy uses far less oil than it used to. But that doesn't mean oil has lost its power to shock.
Most post-war recessions have been preceded by a big jump in the oil price, and it is this gauge of economic stress that policymakers will as a consequence be most keenly focused on as tensions in the Middle East once again reach boiling point.
Nor is it these days just about oil. As oil has waned in importance, liquefied natural gas (LNG) has somewhat taken its place as a component in the global energy mix. And war in the Persian Gulf threatens supplies of LNG just as potently as it does oil supply.
That said, neither the oil nor the market price of LNG has yet risen to a level that would give real cause for concern.
Despite the sharp uptick in recent days, both prices have been higher earlier in the year. And in the case of oil, they remain below where they were throughout much of last year – and significantly below the sort of levels that ruled as the world economy emerged from the traumas of pandemic-induced lockdown.
Traders are still betting on de-escalation in the current conflagration as the most likely outcome, or at least that it will remain relatively contained.
This has been the pattern in recent geopolitical flare ups when, broadly speaking, it hasn't paid off to sell and run for the hills. The US, European and world economies have shown themselves to be remarkably resilient to the various external shocks that have been thrown at them.
But eventually that pattern will be broken. At this stage, it's anyone's guess whether current events will turn out to be the big one.
Assuming Donald Trump holds true to his electoral promise not to get involved in further international conflicts, then it shouldn't. But then again, there is no legislating for how an increasingly desperate regime in Iran might respond.
Let's instead assume the worst, with substantial knock-on consequences for energy prices. How should economic policymakers respond?
For the Bank of England, with an interest rate decision to make this week, the question is particularly awkward.
The Monetary Policy Committee (MPC) is already split three ways: at the last meeting in May, four members voted to cut interest rates by 0.25pc, two wanted to leave them unchanged, and a further two wanted an even bigger cut.
Higher oil prices further increase the policy dilemma. Elevated energy prices are both inflationary and deflationary at the same time – in that they add to costs and therefore to prices – but also leave less money in people's pockets for spending on other things. Cost-push inflation combined with demand-pull contraction.
As it is, the economy may already be slowing fast. Recent data in the UK has all been distinctly downbeat, with the economy contracting sharply in April as hefty increases in tax came into force, and a significant deterioration in the once buoyant jobs market.
It wouldn't take much in the way of higher energy prices to tip the economy into recession.
What is generally considered to be the textbook answer on how to respond to higher oil prices was co-written by Ben Bernanke, the former Federal Reserve chairman – Systematic Monetary Policy and the Effects of Oil Price Shocks – while still an academic.
Virtually all recession in the preceding 30 years, he pointed out, were preceded by both increased oil prices and tighter monetary policy – as the Fed sought to respond to the inflationary pressures brought about by the rising price of energy.
The trick, therefore, is to ignore the pressures for interest rate increases when energy prices are spiking, and to the contrary start cutting interest rates well before recession kicks in. Otherwise, you risk a toxic mix of two deflationary forces at the same time.
That's precisely the trap that Jean-Claude Trichet, then-president of the European Central Bank, fell into in the summer of 2008.
Rampant Chinese demand had caused commodity prices, including the oil price, to sky-rocket, pulling domestic European inflation with them.
With eurozone inflation at more than double the official target, and fearing second-round effects, Trichet raised interest rates, even though it was already obvious that the banking system could be in some trouble.
The European conceit was that any weakness in the banking sector was largely an Anglo-Saxon affair, and that the innate protections of the euro would shield Europe from the worst of the fallout.
In the event, the restrictions of monetary union greatly magnified the effects of the subsequent banking and sovereign debt crisis.
Both the Federal Reserve and the Bank of England avoided this mistake, choosing instead to 'look through' the inflationary surge and take the reverse approach.
Whether in the end it made much difference is arguable. All three economies were soon overwhelmed by the global financial crisis, with interest rates collapsing down to near zero.
All the same, the now tried and tested way to respond to any oil price spike that might be caused by Israel's attacks on Iran would be to ignore the inflationary consequences and accelerate the current cycle of monetary easing.
Just to add to the confusion, however, recent experience with this approach has not been good. Central banks chose to regard the spike in prices that followed the pandemic as 'transitory', leaving interest rates at close to zero.
Second-round effects soon set in, with wages chasing prices, and even now the resulting inflation has not been fully expunged from the system. The experience is going to make policymakers double wary this time around.
As for the Bank of England, it is unlikely there will be a cut in rates this week even if events turn uglier. The Bank has made a habit of only changing interest rates every three months to coincide with publication of the quarterly MPC report. And it would require an extreme emergency to break with this modus operandi.
But a cut in August now looks odds on.
Mervyn King, former governor of the Bank, once said that it was his ambition to make monetary policy boring, in the sense that it would become predictable and people would know exactly what to expect.
Sadly, this was never likely to be achievable in an age defined by what he and fellow economist John Kay have called 'radical uncertainty'.
Globalisation has further clouded the picture, such that events in far off places now have significant consequences in what were once highly localised domestic economies elsewhere.
Barely has one economic shock passed than another is upon us. The global economy acts like a lightning rod, and it has turbo-charged the frequency with which these shocks are felt.
A global recession might have been coming anyway, but if events in Iran further escalate – possibly cutting off supplies of oil and gas through the Strait of Hormuz – it will seal the deal.
We can expect significantly lower interest rates, regardless of the inflationary effects of a soaring oil price, should this be the case.