Will Oil-Price Shock Derail Global Growth?

INTERNATIONAL ECONOMIC OUTLOOK -I. Global Assessment and Outlook Following a $10 per barrel jump in 2004 from the previous year to an annual average of $41 per barrel, oil prices headed gradually up again this year averaging $50 in the first quarter, $53 in the second quarter and hit the 68 dollar mark per barrel in late August. The historical rule of thumb is that for every 10 US dollar increase in oil prices, real worldwide output would decline by 0.5 percent and global inflation would accelerate on average by 0.5 percent in the following year. In the first half of 2005, the global economy continued a remarkable expansion despite the adverse effects of higher oil prices. As we predicted in the spring forecast, currency realignments and high-tech driven productivity improvements have reshaped the global economic landscape leading to economic policies, particularly monetary policies, unparallel to past experiences. With preliminary output growth figures for the second quarter of 2005 now available, the overall global picture for 2005 becomes more fastidious. Quarterly national accounts confirm that the leading economies in the major economic blocs entered a slower growth pace in the first half of 2005. Following an annual growth rate of 3.5 percent in 2004, the combined output of the United States, the Euro Area, the United Kingdom, Japan and China the group accounts for three-fourths of the world's GDP - expanded by an annual rate of 2.7 percent in the first two quarters of 2005, compared with the same period in 2004. The United States was the engine of growth, contributing nearly one half to the 2.7 percent combined growth rate for the group. The sizzling pace of China's expansion in the first half at a 9.5 percent annual rate continued to make a significant contribution to the group's growth. Most important was the unexpected performance of Japan, which matched the growth rate in the Euro Area following years of stagnation. The latest increases in the price of oil are not supported by economic fundamentals. There were several synchronized negative factors in the global oil market which, in combination with speculative forces, put upward pressures in the price of oil: the best global growth performance in 2004 since 1988, the dollar's fall, the Iraqi war and related geopolitical events, and unfavorable climatic changes. In the global business cycle, the United States, the United Kingdom and China continue to climb on the upswing, although at a slightly slower speed than in 2004. It seems that the Euro Area and Japan have bottomed out in the first half of 2005 as current conditions indicators are still weak but forward looking indicators point to a solid recovery. Over the forecast horizon, we expect an adjustment in oil prices. The art of forecasting based on economic forces suggests that what goes up must come down to its long-term natural rate when using dynamic growth rates projections. Our downgrading of the oil shock is based on several expectations: the Iraqi production will resume to higher than the prewar levels, not every year over the forecast horizon will have the hottest summer and the coldest winter on record, not every hurricane will hit oil installations in the Gulf of Mexico, the integration of the markets would provide new investment opportunities for more oil exploration and production, increased energy efficiency, use of alternative sources, the dollar's fall has ended and would be on an upward trend, global economic growth will slow down to its long-term path and, most important, the speculators will move to other markets. In all, if most of these assumptions are realized, oil prices will drop to the low fifties by the end of the year and continue falling to the mid forties in 2006. Looking forward, worldwide output growth is forecast to moderate in the rest of the year and in 2006 and then to accelerate in 2007. The central forecast projects growth in the global economy to slow down in 2005 to 3. …

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