Central Bank Response to $160 WTI Cuts Growth
- We recently revisited our oil price forecast, where we identified that the oil market is tight and, with demand recovering, put forward the case for elevated oil prices through 2022 (WTI at $130 year-end) and into 2023 ($110 year-end). Alongside raised geopolitical tensions, there are sufficient reasons to be uncertain whether prices have completed their upswing. We have modeled a scenario using the macro econometric model NiGEM assuming a still-higher oil price of $160, and we evaluate the impact to major economies. Our results show that in the U.S., Eurozone and China, GDP growth slows by between 0.1 and 0.4 ppt vs. the baseline in the three years following policy response from higher inflation.
- Baseline — Oil market is tight with recovering demand and restrained supply growth (70%): Overall demand growth will likely match supply growth for the remainder of 2022 and early 2023. Oil demand recovery will slow into 2023, but production limitations and inventory levels below average will keep prices elevated. Our baseline view for WTI oil prices for end-2022 is $130 and $110 for end-2023.
- Upside — (20%): The alternative scenario is for $160 WTI oil prices by end-2022 and into early 2023 and $140 by end-2023. (Note that a downside scenario of a greater slowdown in oil demand growth has a 10% probability, but we do not model here).
Figure 1: Higher Oil Prices Mean Slower GDP Growth in US, EZ and China Relative to Baseline
Source: Continuum Economics, NiGEM
Baseline
Our baseline view for WTI oil prices for end-2022 is $130 and $110 for end-2023. Our baseline view includes disruption from the ongoing war in Ukraine, which we expect will become a frozen conflict into 2023 without a peace deal, leaving restrictions on Russian exports to Western countries. Additionally, it will take until well into 2023 for Russia to find alternative buyers for the seaborne EU oil ban, given existing contracts in Asia with other oil producers. Into 2023, our baseline sees oil prices easing somewhat, due to slowing oil demand; pickup in U.S. shale production; and less disruption to Russian oi exports.
Upside Scenario
We apply a temporary, albeit extended, path of higher benchmark oil prices beginning Q2 2022 through to Q4 2024, to reflect WTI reaching a peak of $160 by early 2023 (Figure 1). We model the impact of this scenario on our in-house baseline forecasts using NIESR's global macroeconomic model, NiGEM.
The upside scenario can come from greater supply disruptions than expected, either as Russia finds it more difficult than expected to find alternative buyers or OPEC+ lags output quotas more significantly due to aging infrastructure. Additionally, uncertainty exists over the feed-through of below-normal global oil inventory levels, and this could mean more elevated oil prices than in the central scenario. This upside scenario for prices uses the assumption of $160 oil prices for end-2022 and extending through Q1 2023, before coming down to $140 for end-2023 and then $100 for end-2024.
It is also worth noting that oil prices are subject to demand, supply and financial market expectations. Demand for oil is largely a function of economic growth and energy intensity of consumption, while supply is affected by fundamentals such as production capacity and oil reserves. The economic impact of higher oil prices tends to be unevenly distributed between countries. Net oil importers that have a large share of energy consumption tend to suffer a deterioration in the current account and higher outflows, which pushes down their currencies and raises inflation. Net exporters do relatively better, with improved external positions and foreign currency reserves.
We focus our analysis on the U.S., China and Eurozone.
In NiGEM, higher oil prices directly raise import prices, making terms of trade worse — meaning reduced trade between countries — and indirectly increasing the marginal cost of production. This pass-through to consumer prices lifts inflation expectations and therefore inflation itself. In terms of modeling, given the sustained nature of this shock, we assume that central banks' reaction functions remain endogenous. That is, bank policy rates adjust automatically within the model according to 1) deviations of inflation from target and 2) changes in nominal GDP.
Figure 2: Central Banks Quickly Hike Rates, but by 2025 Most Are Back to Baseline
Source: Continuum Economics, NiGEM
Higher inflation feeds into central bank reaction functions, as expectations become de-anchored from target levels and central bank policy rates are raised to bring them back into line. Interest rates become elevated across the U.S., China and Eurozone in the scenario, compared to our baseline forecasts (Figure 2). These major central banks react quickly. The Fed tightens by an additional 50bps in 2022, but then cuts more than baseline in 2023 as the oil price begins to fall (but remains high relative to baseline), and then gradually increases rates back to the baseline (Figure 2) as the inflationary pressures ease off.
The ECB also moves, raising rates by 50bps more in 2022 than the baseline, and then eases policy in the following year as oil softens. The central bank then returns to its pre-shock path of interest rate normalization back to our baseline of 1.5% by 2025. Similarly, the People's Bank of China (PBoC) acts to bring inflation under control by tightening policy by 25bps in year one of the shock, and is also able to ease back in year two, before shifting to a slightly higher-than-baseline path for rates.
Higher inflation lowers real disposable income, and tighter monetary policy dampens borrowing and in effect consumption and investment. Figure 1 shows softer domestic and foreign demand reflected in slower GDP growth for all three. GDP growth slows by a tenth of a percentage point in 2022, but it isn't until 2023 when the effects of tighter monetary policy feed through and begin to be more fully felt by the real economy. The U.S. and China lose around 40bps off GDP growth in year two, meaning that the U.S. contracts by 0.1% (our 2023 U.S. baseline is a weak +0.3%) and China grows by closer to 5%. Eurozone growth slips by 0.2 ppt in 2023 to around 1.5%.
Policy reaction to the impact of higher oil prices continues into 2024. Lagged monetary policy effects are felt most strongly in the U.S. and China, which absorb another 0.2% hit to growth in year three, while the Eurozone loses another tenth of growth. By 2025, with the oil price shock and monetary policy response washed through the system, GDP growth is also normalized.
WTI Peaks at $160: Scenarios at a Glance
Source: Continuum Economics