The 550bn global stimulus

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Oil prices have fallen sharply this week on the back of OPEC’s decision to keep supply unchanged. The price of a barrel of Brent crude has now fallen by USD 40 over recent months. That is fantastic news for the global economy, which is likely to benefit from a major tailwind. Lower oil prices could eventually provide oil importers with a USD 550bn windfall, which equates to 0.7% of global GDP. Lower oil prices are also good news for the eurozone economy, but they are pushing inflation even further away from the ECB’s goal. This makes further monetary easing even more likely.

That is fantastic news for the global economy Nick Kounis Nick Kounis Head of Macro Research

OPEC sits on its hands, leading to oil price slide

OPEC decided to leave its production level at 30 million barrels per day.  Its failure to reduce supply sent oil prices sharply lower, leaving them almost USD 10 per barrel lower compared to the end of last week and 35% less than a year ago. Over the last few years, the oil market has moved from a relatively tight balance between demand and supply to a situation where there is plentiful supply relative to demand. Oil prices seemed to take some time to adjust to this development, partly because investors factored in the risk of supply disruption due to various geopolitical events. 

Many underestimate ability of markets to adjust

In times like this, many commentators underestimate the ability of markets to adjust. In 2007-08 some analysts speculated about a structural shortage of oil and predicted that oil prices would surge towards USD 200. Instead both demand (helped in no small part by the global financial crisis) and supply adjusted to the new situation, which over time brought prices back down to more normal levels.  Lower oil prices will probably also work to cap supply, while also supporting demand. Indeed, our oil analyst, Hans van Cleef, judges that oil prices will bottom out over the coming weeks.

Here comes the real bazooka

Compared to earlier this year, oil prices are now down by USD 40. The slide in oil prices is fantastic news for the global economy and will provide considerable tailwind to economic growth in the coming months. When oil prices fall, money is transferred from net oil producers to net oil consumers.  We calculate that the decline we have seen so far would provide a USD 550 bn windfall for oil importers over a year. This equates to 0.7% of world GDP. Although it is a zero sum gain – someone’s win is someone else’s loss – consumers are far more likely to spend the funds especially in the near term. Compared to the European Commission’s investment plan – involving EUR 21bn in new funds – and the G20’s empty words about boosting global growth – the oil price decline is the real bazooka.

Oil prices slade a tailwind for global economy

A good-news-bad-news story for Mario

Of course the fall in oil prices is also good for the eurozone economic outlook. However, it also leads to lower inflation in the near term. Should a central bank react to lower oil prices? Normally, the answer is no. A one-off fall in oil prices can depress the year-over-year rate of inflation for a year, but after that it will fall out of the numbers. In addition, given that it boosts demand, the prices of other goods and services could actually rise. However, there is a big ‘but’ that is relevant to the current situation.  A decline in oil prices could have more permanent effects on inflation if it leads consumers and businesses to change their expectations of future inflation, which could have knock on effects on their wage and price setting behaviour. Inflation fell to just 0.3% yoy in November and will flirt with zero in coming months as the decline in oil prices feeds through. The ECB is already worried that an ongoing long period of inflation rates nowhere near its inflation goal closer to 2% will ruin its credibility to deliver, which could lead to low inflation becoming entrenched. Low inflation makes the economy more vulnerable to deflation in case of a new economic shock, and could keep real interest rates higher than they should be. The BoJ faces similar considerations.

Oil prices pulling down inflation expectations

The ECB’s next steps

Overall, the fall in oil prices therefore adds to the already high likelihood that the ECB will take further steps to put more money into the eurozone economy.  That is the easy part. The more difficult question is what the central bank will do and when.  The ECB expects a lot from the TLTROs (4-year low cost loans to banks) in terms of its plans to expand its balance sheet by a trillion euro. The December operation  will provide a very strong signal about how successful the TLTROs will be. We therefore expect the Governing Council to wait until next year before deciding on an expansion of its asset purchase programmes.

Making TLTROs even more attractive

At next week’s meeting, there is a possibility that the central bank will ease the conditions of the TLTROs in order to increase the chance of a bigger take-up later in the month. Since the TLTROs were originally announced, alternative sources of bank funding – especially covered bonds – have become cheaper. So reducing the lending rate on the TLTROs could be an option. In addition, the ECB could allow banks to borrow more.

Broadening of asset purchases next year

Early next year, we expect the ECB to expand its asset purchase programmes.  The Governing Council  is split about whether government bonds will be part of the mix. Bundesbank President Jens Weidmann argues there would be large ‘legal hurdles’ while ECB Vice President Constancio has made a strong case that they are within the ECB’s legal mandate. ECB President Draghi has been sitting on the fence saying that there is an ongoing discussion and all options are open.  We think that the central bank will probably steer clear of government bonds, and instead expand its programmes to include agency debt and corporate bonds. However, if the December TLTRO disappoints, then the ECB would have no option but to also include government bonds, as it would otherwise not be able to achieve the balance sheet expansion it wants.  The chances of sovereign QE are therefore significant.

Impressive economic growth in the US

Last week’s economic data suggested that the global economic recovery remains on track. US GDP growth was revised up in the third quarter.  The economy is now reported to have expanded by 3.9% compared to 3.5% before. This is quite an achievement given that the GDP surged by 4.6% in Q2. Some of the monthly data for October – such as durable goods orders – suggest that the economy may have lost some momentum in the fourth quarter. Nevertheless, it is still early and orders data can be volatile. In any case, the economy looks to be still expanding at rates that are comfortable above its long-term trend.  Meanwhile, the Fed’s preferred measure of consumer price inflation (the personal consumption deflator)  rose by just 0.1% in October, leaving the annual rate stable at 1.4% yoy. However, that reflected lower oil prices. Core inflation (excluding food and energy) was up by 0.2%, taking the annual rate to 1.6% from 1.5%. Lower oil prices and a stronger dollar will likely keep inflation subdued over the next few months, but the stronger economy should eventually push inflation back to the Fed’s 2% target in the second half of next year.

Signs of life in the eurozone and Japan

Meanwhile, the laggards of the global economy also showed some tentative signs of slow recovery.  Germany’s  bellwether business climate indicator – the Ifo – rose in November, ending a run of six successive drops. The European Commission’s economic sentiment indicator also rose in November. Although it was only a very slight gain, it built on a more significant rise in October. Overall, eurozone data appear to be turning for the better, in line with our view that a slow recovery is more likely going forward than a third recession.  Japan unfortunately did fall into recession in the third quarter, but there are signs that it is returning to growth this quarter. Industrial output rose by 0.2% mom in October  after a 2.9% jump in September. 

To top off the positive news from global laggards, the Brazilian economy climbed out of recession in the third quarter.  Granted, 0.1% qoq growth is nothing to write home about, but it is better than the 0.6% contraction seen in Q2. We think the Brazilian economy will get a lift on the coat tails of the US recovery. Finally, India has been one of the better performing emerging markets. GDP growth slowed to 5.3% in Q3 from 5.7% in Q2. However, growth rates still remain significantly higher than at the turn of the year, and we expect them to firm going forward.


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