Global recessions have often been preceded by a sharp increase in the oil price, as this acts as a constraint on household and corporate demand. By contrast, large falls have tended to be followed by stronger global growth.
Macroeconomic models suggest that the boost takes place with a lag of about one year, as firms and households come to believe that the fall will be sustained. Lower oil prices act as a tax cut for consumers and many corporates, by reducing the prices of transportation and other energy dependent goods and services.
Models also tend to assume that the propensity to spend additional income among oil-consuming countries is larger than that in oil-producing economies, a not unreasonable assumption based on past experience.
So much for the theory, what about reality?
To date, the sharp fall in the price of oil has created a lot of “bad news”. It has hit the manufacturing sector via a sharp fall in oil-related capex, damaged public finances in oil producing states with relatively young and restless populations and driven headline inflation into negative territory.
There have even been fears that cheap oil will trigger a financial tsunami, followed by global recession, as a result of debt default contagion from high yield corporate debt. There is less evidence that cheaper oil has given a major boost to the global economy, although global growth may have been even weaker without it. We expect the focus to shift towards the winners from cheaper energy and away from losers during 2016.
What matters is not just that the oil price has fallen, but why it has fallen. Supply driven falls tend to create a more benign scenario of “good disinflation”, which boosts real incomes, while demand led falls are evidence of a significant slowdown in the global economy. Some of the recent fall reflects lower expected oil demand, however most reflects higher expected oil supply and a long period of overinvestment in production which needs to be worked through. The latest decision by OPEC not to restrict production can only add to evidence of a supply driven shock.
The US is an important test case for the positive impact of cheaper oil, since it is both a major producer and consumer. A low oil price has squeezed oil production and had a knock on effect to manufacturing; however the effect on the overall economy should be offset by the boost to household demand and non-energy US PLC.
