Modelling the Oil Price Impact
May 09, 2006
Takehiro Sato (Tokyo)
We have examined the sensitivity of real GDP growth and prices to changes in our oil price assumptions, as an interim measure before revising our official outlook after GDP data for January-March are released on May 19.
Looking only at the income transfer effect under high oil prices, we calculate that raising our price assumptions by approximately 15% for 2006 and 40% for 2007 would depress real GDP growth by about 0.2pp for each year, compared with our current outlook. The impact on the core CPI is +0.1pp for 2006 and zero for 2007. This approach implies a smaller impact than a simple elasticity model, especially for prices, partly because we assume that oil prices will fall in 2007 and that the yen will appreciate.
We can sustain our basic stance — bullish on the economy, cautious on prices — even under dramatically higher oil price assumptions. But event risk, bearing in mind geopolitical considerations, is rising.
(1) Oil-producing countries might raise their saving rates, even if only temporarily, leaving the global economy facing a consumption and investment shortage; (2) Oil prices might remain high in 2007 if China’s economy fails to slow or geopolitical risks emerge; and (3) Yen depreciation, in defiance of the current JPN/USD trend.
Japan’s economy still holds up well under high oil prices, but the issue is worth another look
We have emphasised repeatedly the extreme resilience of Japan’s economy in the face of high oil prices, as a result of its high energy efficiency and the effect of recycling oil money. However, it has become impossible to gloss over the impact of this factor entirely, at a time when our global economics team has significantly increased the oil price assumptions in its macroeconomic forecasting model, particularly for 2007. We are intending to release a new forecast for the economy and the prices based on new oil price assumptions following the reporting of the first set of preliminary GDP data for the January-March quarter on May 19, but as an interim measure we examine here the sensitivity of real GDP growth and prices to different oil price inputs.
Impact of different oil price assumptions is negligible
Our provisional calculation looking only at the income transfer effect of high oil prices indicates that raising price assumptions by approximately 15% for 2006 and 40% for 2007 would depress real GDP growth by about 0.2pp for each year, compared with our current economic outlook. The impact on the core CPI (Japan-style core index) based on the bottom up approach is +0.1pp for 2006 and zero for 2007.
The impact above is quite a bit smaller than that implied by a straightforward calculation from price elasticity. The latter approach suggests that a 40% increase in the oil price would depress real GDP by 0.9pp and push up the core CPI by 0.9pp. This discrepancy stems from our methodology, in which we calculated the difference of impacts from 2005 in terms of the change from our old baseline to the new baseline. Also, the dull sensitivity of prices despite the hefty upward revision is based on the assumption that the oil price will drop sharply towards the end of 2007, while recording a high average level during that year, and also the assumption of a strong yen/weak dollar rate advancing to ¥102/$1 in 2007. This results in the somewhat confusing circumstance, especially for fiscal 2007, of a negative statistical impact on the core CPI in YoY terms despite the rise in oil prices.
The downward revision of the GDP deflator, in contrast to the inflation in the core CPI, comes about because oil imports are a deduction item in GDP calculations. Since a rise in the import deflator pushes down the GDP deflator, the effect of higher oil prices thus works in opposite directions on the core CPI and the GDP deflator. This is obvious if the GDP deflator is understood to be a type of proxy for corporate earnings.
Why the income transfer effect and elasticity approaches have missed the mark
In any case, the income transfer approach used above still produces a negative effect from higher oil prices. The issue is how reliable this approach is. Japan’s economy has maintained a 2-3% trend for real growth over the last three years, while the oil price per barrel has soared from $30 to the $60 plus range. The impact of oil prices has become harder to discern, particularly since the sharp spike in summer 2005, as this has coincided with the emergence of Japan’s economy from a prolonged soft patch.
To explain why the economy has performed favourably despite the spike in oil, we focus on Japan’s high energy consumption efficiency and the effect of the recycling of oil money back to advanced economies, points we noted at the outset. In terms of unit energy consumption (oil consumption volume required to generate $1,000 in real GDP), Japan is second only to Switzerland. Quantitative assessment of the oil money recycling effect is tough, but visible to some extent in the shape of demand for aircraft and chemical plant orders from oil-producing nations. Demand from oil-consuming nations is crimped to an extent by the transfer of income to oil producers, but since new demand is generated from the latter we can judge that higher oil prices have prompted the global economy to reach an equilibrium point at a higher level. The national drives by oil-consuming nations to improve productivity in response to the external jolt of higher oil prices have also played a key role in absorbing oil shocks. The benefits of this income transfer have so far offset the impact of more expensive oil, and it is credible to think that they will continue to do so up to a point.
Where the risks lie
The question is whether these positive effects that have functioned as a shock absorber to date while the price of oil has climbed from $30 to over $60 could keep doing so at levels of $70, $80 or even higher. If high oil prices become entrenched, the economy is likely to naturally adjust to this reality (recognising that this is not ephemeral) and reallocate production resources accordingly. Specifically, investment in energy-related fields that constitute economic infrastructure may become a more critical capex component than IT, and development of energy-saving technology and alternative energy will likely assume higher priority. In this respect, we can expect productivity improvement via technological progress to keep on offsetting the impact of higher oil prices in the same way as to date.
What about the recycling of oil money? We are somewhat sceptical here. There is no indication as to whether the savings rate (strictly speaking, marginal propensity to save) of oil-producing countries would stay at the same level if the price of oil climbs from $70 to say $100 as it has during the ascent from $30 to $60. In other words, oil producers might raise their saving rates, even if only temporarily, rather than maintain the same pace of increase in consumption and capital spending per unit of income at higher future oil price levels. That could leave the global economy facing a consumption and investment shortfall, and quash the demand kickbacks that higher oil prices have generated to date.
Another risk for Japan is the foreign exchange rate. Our global team is forecasting yen strength/dollar weakness up to ¥102/$1 in 2007. A yen this strong would be pivotal to absorbing an oil shock. But if the rate swings the other way, with the yen dropping and the dollar appreciating, Japan would be exposed to a double whammy. We do not regard this as an immediate risk, with the direction of monetary policy in Japan and the US favouring a stronger yen and weaker dollar, but it is one that should be noted.
Finally, our house view for a sharp drop in the oil price in 2007 is based chiefly on the assumption that China’s economy will cool. If it does not, this too can be considered a risk. For example, event risk inherent in the current geopolitical situation could also forestall a meaningful drop in the oil price in 2007, and that danger should also be weighed.
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