Stephen King: Markets worry too much about oil price risks

China and India will place upward pressure on commodity prices, but will also place downward pressure on wage levels
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There's a sense of unease in the air. The global economy may have expanded at a remarkably rapid rate over the last couple of years but, somehow, markets seem to think that the story may be too good to be true. Since the beginning of 2005, equities have struggled to make any real progress. Bond markets have sold off. And the dollar, after an initial rally, has slumped once again.

There's a sense of unease in the air. The global economy may have expanded at a remarkably rapid rate over the last couple of years but, somehow, markets seem to think that the story may be too good to be true. Since the beginning of 2005, equities have struggled to make any real progress. Bond markets have sold off. And the dollar, after an initial rally, has slumped once again.

What, perhaps, is more surprising is the apparently fickle nature of financial market reactions. Actually, "fickle" probably isn't the right adjective: if anything, markets have been downright inconsistent. The things they worry about may still be broadly the same. But their reaction to these similar worries appears to have changed direction.

One obvious area of concern is oil prices. They rose last year when most economists at the end of 2003 thought that oil prices would fall. And they're still going up now. The most recent low point for oil prices was seen in spring 2003, when they were down at around $25 per barrel. Since then, they've climbed and climbed. There have been occasional interruptions - notably towards the end of last year - but they're now heading back up to $60 per barrel. Few thought that oil prices would ever get to these levels.

But it's not oil prices themselves that are fickle or inconsistent. Rather, it's the reaction of financial markets. In the summer and early autumn of last year, when oil prices spiked upwards, bond yields fell and equity prices softened. This time around, equity prices have moved sideways, but bond yields have risen (see charts).

Why have bond markets reacted so differently this time around? Part of the problem lies with the interpretation of oil price movements. On one interpretation, higher oil prices are the equivalent of a tax increase. They reduce incomes, lower demand and, hence, are bad news for economic growth. In the language of international trade, higher oil prices represent, for oil-consuming nations, a deterioration in the terms of trade.

On another interpretation, higher oil prices are a threat to price stability. Higher oil prices, by leaving consumers and companies worse off, threaten a series of compensating wage and price increases. A wage-price spiral might then develop, leading to slower growth but, at the same time, higher inflation. And, as policymakers learnt from the bitter experience of the 1970s and early 1980s, this kind of inflation is particularly painful to stamp out once it gets going.

Of these two broad possibilities, the first could be seen as bond market "friendly" - weaker income growth and lower demand should, in time, lead to lower inflationary pressures and, therefore, lower interest rates. The second possibility, though, is more likely to be bond market "unfriendly" - by implying a return to the economic conditions that prevailed in the 1970s, bond holders might worry about inflation eroding the real value of their savings and would, therefore, demand compensation in the form of higher interest rates.

Could it be, therefore, that for the same "external shock" - a rise in oil prices - bond investors have changed their minds over the last 12 months? Could it be that they feared recession 12 months ago but now fear inflation? It's certainly possible: all of us know that markets can change their minds, that the same information can be treated in different ways depending on the economic model that's most in vogue.

Why might markets worry more about inflation now than in the middle of last year? One obvious reason is that the global recovery has gone on for that much longer and, therefore, spare capacity is not so readily available. Some parts of the global economy - notably China - have continued to expand at a rapid rate despite the authorities' attempts to cool things down. And, as China is seen to be the world's pre-eminent consumer of commodities, it's hardly surprising that commodity prices have remained buoyant. This is, potentially, an important factor. In the middle of last year, the world economy was going through a soft patch, partly caused by higher oil prices. If the soft patch has ended, and oil prices are higher still, perhaps inflation, rather than growth, might now be the bigger risk.

Then there's the performance of the dollar. Oil prices are bound to be strong in an environment of dollar weakness. When the dollar falls, oil prices go up or - alternatively, because this is always a relative game - the price of dollars falls for a given value of oil (measured in euros, oil prices have been nowhere near as strong). But dollar weakness was a theme last year as well and bond markets weren't spooked: so why should they worry about dollar weakness today?

Perhaps it's because US short-term interest rates have risen at only a moderate pace (suggesting that the Fed remains unsure about the foundations of the current economic recovery.) The talk in financial markets now is that the Fed is "behind the curve", that short-term interest rates remain well below the level that would be associated with ongoing price stability. If that's true, the US economy is unlikely to be immune to the inflationary effects associated with higher oil prices.

So, rationalising the shift in the mood within financial markets seems to be relatively straightforward. Growth has been stronger, the dollar has been weaker, monetary conditions still seem to be loose ... but, despite all this, I'm not convinced. It's not so much that the mood in financial markets may have shifted towards worries about the inflationary consequences of higher oil prices. It's rather that the facts may not fully support this shift in mood.

The problem lies in the relationship between profits and wages. Higher oil prices suggest income losses which, in turn, point to downside risks for either profits or wages. If inflation is to rise, we have to see some evidence of wage and price increases coming through to compensate for the income losses associated with higher oil prices. So far, though, profits have fared remarkably well without price increases, at least not at the consumer level: profits as a share of GDP are very high more or less the world over. Companies, therefore, appear to have been broadly unaffected by higher oil prices.

For labour incomes, it's a rather different story. Western workers may have seen their take-home pay squeezed as a result of higher oil prices but they've not been able to do much about it. They might ask for higher wages as compensation for higher oil prices but the chances of success are low: the mobility of capital is now so high that relatively well-paid Western workers will always be vulnerable to the threat of outsourcing. In effect, globalisation has reduced Western labour's pricing power.

Financial markets struggle with these sorts of themes. Previously reliable relationships between, say, commodity prices and inflation work less well in our new, global, environment. Changes in relative prices are coming through thick and fast and may no longer be the harbingers of inflationary pressures. The integration of China and India into the world economy will certainly place upward pressure on commodity prices - more demand for a relatively fixed supply - but their integration will also, for many industries, place downward pressure on wage levels. Working out the inflationary implications of these two opposing forces is extraordinarily difficult. And, because of this, you shouldn't always take a shift in mood within financial markets as a statement of reality. Oil prices may have risen further and inflationary worries may have grown, but I suspect that the underlying upside risks to ongoing price stability are really rather low.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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