The economics of oil prices: Crude hope, complicated reality

It used to be all so easy.

To paraphrase George Orwell: lower oil prices good; higher oil prices bad.

That is no longer quite so obviously true. While there is evidence to suggest lower oil prices today reflect some beneficial supply-side shocks—increased U.S. production, an OPEC cartel fraying at the edges—it is impossible to ignore the role of weakening global demand.

Indeed, lower oil prices are partly a reflection of broader deflationary trends.

History suggests lower oil prices tend to boost global growth and reduce global inflation. Yet some of the routes that led to these results are now partly closed off.

In the 1980s and 1990s, the Federal Reserve typically lowered interest rates in response to falling oil prices: with rates at the zero bound, the Fed can no longer do so (and, even if it could, it probably wouldn’t choose to do so yet). Equity price gains may have been more a reflection of lower interest rates than of lower oil prices.

And today’s high debt levels in the industrialized world suggest that positive multiplier effects may be smaller than in the past.

For policymakers hoping to keep the deflationary demons at bay, lower oil prices are both a blessing and a curse: they may boost real incomes
(similar to an indirect tax cut) but they may also reinforce expectations of a continuously falling price level. For those central banks determined to raise inflationary expectations—most obviously the Bank of Japan and the European Central Bank—falling oil prices may prove to be an unwanted complication, threatening more instability in the foreign exchange markets.

Lower oil prices will help some parts of the emerging world—notably India and Turkey—even as other parts suffer.

More generally, however, lower oil prices may only serve to emphasize the difficulties central banks have in slaying the deflationary monster.

Click here to read the full report: The economics of oil