There is broad agreement in the investment community that the steep slide in oil prices will serve to support world growth through a number of channels. Low oil prices should feed through to gasoline prices and free up consumer funds for spending on other goods and services. Indeed, we may be seeing this benefit already in the US—November retails sales surprised to the upside this week and have led many street economists to revise up their fourth-quarter growth forecasts. In addition, by reducing inflationary pressures, low energy prices can lead to an easier monetary policy stance in many economies. Given these and other effects, a recent study by the Institute of International Finance estimates that global growth could be boosted by roughly 0.5% over two years should the decline in oil prices be sustained.
Figure 1: Crude oil prices year-to-date
That the effects of lower oil prices are felt unevenly across countries constitutes a second market truism. While oil importers will experience improved terms of trade, exporters will experience the opposite and with it a deterioration in current account balances. And some countries that are highly dependent on oil exports for a large share of government revenue may need to compensate by reducing spending or raising taxes.
Unsurprisingly, the uneven impact of lower oil prices across countries is driving a significant divergence in asset and currency performance. Over the last few months, equity indices, sovereign bonds and currencies of oil exporting nations have generally underperformed those of oil importers. More recently, sovereign credit default swap spreads of some oil exporters have begun to widen notably. However, with OPEC’s late-November decision not to adjust oil levels, there are growing signs that asset prices in oil importing countries are not immune to the negative side effects of oil price declines, despite positive long-term growth implications. The slide in front-month Brent oil prices to close to US$60 per barrel over the two weeks through December 15 2014 has so significantly pressured equity and currency valuations for oil-exporting countries that global risk sentiment has deteriorated. Optimism over growth effects of low oil prices has given way to an increase in risk aversion. In the week ending 12/12/14, US equities put in their worst weekly performance since the spring of 2012, and the Chicago Board Options Exchange Market Volatility Index (VIX), an index of equity-implied volatility, has spiked. Globally, stock price weakness has broadened out from oil and other energy-related firms and is impacting equity returns in both developed and emerging markets. Increased risk aversion and flight-to-quality flows have contributed to US-dollar strength, and US credit spreads have also widened. Of course, high yield spread widening is not solely due to an exogenous risk-off event; bond spreads of many high yield companies in energy-related industries have come under considerable pressure as their leverage levels now look less sustainable given cloudier revenue prospects.
Policy implications of the sharp decline in oil prices are now coming into focus. The central banks of both Russia and Nigeria have increased policy rates and reportedly intervened in currency markets to push against currency depreciation. Going forward, a wider set of countries may face similar policy tradeoffs between supporting currencies and near-term growth. Meanwhile in Norway, Europe’s largest oil producer, the central bank unexpectedly cut its policy rate by 25 basis points due to a deteriorating growth outlook. In the Eurozone, the decline in oil prices may increase pressure on the European Central Bank (ECB) to expand quantitative easing to sovereign bonds at its January meeting. Central banks often look through energy price swings to core inflation components, but the ECB may have little room to take a wait-and-see approach given that inflation expectations are already becoming unanchored to the downside and core inflation trends have also disappointed. In addition, this week’s targeted long-term refinancing operation (TLTRO) added only €90 billion of net liquidity. This suggests that current easing measures will not be sufficient to expand the ECB’s balance sheet by the intended €1 trillion.
The impact on US Federal Reserve (Fed) policy is less clear. The pace of job creation has picked up over the past several months, which in combination with higher equity valuations and lower gasoline prices has boosted consumer confidence to a new high for this expansion. So long as growth momentum continues apace, the Federal Open Market Committee is likely to look through the near-term inflation impact of low energy prices, and we retain our view that the first interest rate increase will occur at the June 2015 meeting. Oil-related risks to this outlook include reduced investment and hiring in the energy sector, weaker home prices in regions where oil and gas extraction are key engines of growth, and reduced inflation, both realized and expected.
In the near term, investors will look to see if the Committee removes the “considerable time” guidance from its policy statement after the meeting on 16-17/12/14. The probability of such a change is certainly higher in the wake of the strong November employment report. In addition, the Committee has shown a preference for making significant communications changes at meetings with press briefings. However, this language change risks investors pulling forward the expected date of a first interest rate increase, as “considerable time” is commonly thought of as six months. In the prior tightening cycle, the Committee made a similar language change just five months ahead of the first rate increase. So if the Committee does indeed change its forward guidance, expect it to be accompanied by offsetting language aimed at keeping market expectations for liftoff centered on the June meeting, or even later. Such language would likely underscore that soft inflation readings and the continued decline in inflation expectations allow the Committee to remain patient in starting to raise rates. Alternatively, patience may simply argue for keeping the “considerable time” in place until the January 27-28 meeting, and would mitigate risks of a near-term communications error.