The Real Risks of Oil Price Spikes

A supply-driven oil shock may start with inflation, but Morgan Stanley’s Senior Global Economist Rajeev Sibal discusses why investors need to understand the second-order hit to growth, policy and markets.

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Rajeev Sibal: Welcome to Thoughts on the Market. I'm Rajeev Sibal, Senior Global Economist at Morgan Stanley. 

Today, economic risk from an oil shock isn't the price of oil itself – but really what happens next? 

It's Tuesday, April 7th at 3pm in Dubai. 

An oil shock doesn't stop at the gas pump. It ripples through inflation, growth, central bank policy, and ultimately markets. As you've heard from my colleagues over the past several weeks, this time may be different. We're not just dealing with a temporary price spike. The closure of the Strait of Hormuz is historically unprecedented. We're well over a month now, and we're looking at the implication of a supply shock that could last many quarters. This could evolve into something far more complex. 

This is a tricky mix of rising inflation and slowing growth, and the sequence matters greatly. At Morgan Stanley, a collaboration between the economists and the strategists globally looked at a wide range of scenarios of where oil prices may go. 

If the Strait of Hormuz were to reopen rapidly, we would see oil prices probably decline rather quickly. That doesn't mean that the problems from the oil shock are going to go away very quickly. But it does mean that the price of oil may move down more quickly. Conversely, if we see a complete closure and an escalation in the conflict, the oil price is probably going to go much, much higher. And in a world where oil moves past $125, which is usually the level at which demand starts to destruct in the economy, i.e. people have to reduce their consumption of oil because of the price, we would see a much more dramatic impact in the global economy. 

Right now, we're in the in-between scenario. We see oil hovering between $100 and $125 for a number of weeks now, and this creates a lot of questions and confusions and modeling problems for many central banks. I want to go through some of the key regions of the world to talk about how they are reacting to what is happening right now. 

Asia is a little bit unusual. Asia is the most exposed to what's happening in the Middle East. Most oil and gas that leaves the Middle East goes to Asia in terms of physical volumes. The challenge is that many Asian economies have huge buffers in place or reserves. They also use fiscal policy to help subsidize and smooth the price of oil so that the consumer does not experience the shocks as dramatically as they would otherwise. 

As a result, there is a mix of countries in Asia that are grappling with figuring out how much support they should continue to provide but also making sure they have physical volumes in place because of the closure. This creates a rather mixed effect from central bank policy and a mixed effect from inflation and growth. In some economies, you're seeing prices move very rapidly and growth being affected very rapidly, whereas in other economies it's been delayed. We expect this mix to continue for the next few quarters. 

The euro area is a contrast to Asia because in the euro area inflation passes through very quickly. Historically, inflation reacts not only at the headline level, but also at core. As a result of this, the ECB has indicated that they are likely to raise interest rates in the near future because they don't want inflation expectations to become unanchored. They're more concerned about the speed of inflation than the growth risk right now. 

This is a big contrast to the Federal Reserve. In the United States, actually, oil supply shocks do not move core inflation as much as they do in many other regions of the world. The effect is on headline inflation and on consumption, but not necessarily on core inflation. 

We have to remember; the U.S. is primarily a services-based economy. As a result, the Fed is more likely to look through the effects of the supply shock and be focused on growth simply because the core inflation pass through is far less than it is in many other economies. As a result, the Fed is thinking more about the growth risks from higher prices of the pump than they are about the price risks – and what that transmission means to inflation in the United States. 

This is a big contrast to many other regions in the world, but I think the important thing to remember is that in every economy, in every region, there's a different reaction. Inflation will always lead in terms of oil supply shocks with growth following. But the way that that passes through in each domestic economy is very different. And that means that central banks have to react differently. It also means that potentially, if this lasts for a couple more quarters, fiscal policy will also react differently. 

The challenge for market participants, economists, and strategists will be figuring out the exact scale of disruption from the oil shock. For now, we know that we're talking about quarters and not months. And that in and of itself means that we expect growth downside risks to outweigh inflation upside risks.

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