Why is the oil price drop not boosting the economy? – Hermes

Added 20th April 2016

The drop in oil prices has not fed through to economies in as strong a way as many expected, but ultimately the price drop will be expansionary at the global level, said Eoin Murray, head of Hermes' investment office.

Why is the oil price drop not boosting the economy? – Hermes

Usually a drop in the oil price is expected to provide a positive boost to the economy - the balance between a negative effect on the growth of exporters would be more than offset by a positive effect for oil importers.

But despite the sharp fall from 2014’s high oil prices the demand boost predicted by economic theory has not materialized, which is puzzling. “Instead we have seen a strong positive relationship develop between the oil price and equity markets, with a near doubling of the correlation,” explained Murray.

He argues that the complexity of modern financial markets and their intertwining with the real economy could help us to solve this question. There are two different issues at play: oil price declines brought about through an increase in global supply; and those that occur due to a drop in global demand, according to Murray. “The latter phenomenon could partly explain what we have observed – slowing global growth cushioned by lower oil prices,” he added.

Recent academic studies, including an IMF blog post on global implications of lower oil prices, suggest that slowing global demand could account for as much as a half to a third of the fall in the price of oil.

And a large part of the answer resides in the recent extreme monetary policies seen on a global scale. “For lower oil prices to feed through to positive economic growth, one would typically expect a boost in spending, but we have not seen any evidence of that this time – rather, public investment has been falling, and many countries have no capacity for any additional borrowing that could provide the necessary stimulus,” said Murray.

This is because all major central banks have been pursuing unconventional monetary policy following the financial crisis, rendering them impotent to lower rates any further to boost growth alongside the reduction in oil price, according to Murray. “A fall in long-term inflation expectations can feed through to stifle the increases in output and demand that we would otherwise expect,” he said.

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