The Oil Price and World Balances
Barrell, Ray, Holland, Dawn, National Institute Economic Review
World growth accelerated to its fastest pace in 28 years in 2004, reaching 5.1 per cent. Global growth well above trend reflected strong domestic demand in the US, France, the UK, Canada and Spain, as well as oil exporting nations such as Russia, Mexico and Opec members. Japan and China also benefited from a strong boost to net trade, with world trade growth rising to 9.1 per cent following 3 years of sub-trend growth. GDP Growth in both the US and Japan rose well above recent trends last year, while the UK and Canada also performed relatively well. We also saw a strong acceleration in South America and Africa. The Euro Area remained weak relative to the other major economies, but nonetheless GDP growth accelerated by a full percentage point relative to 2003, to 1.7 per cent.
The outlook remains buoyant on a global level, with world GDP expected to rise by 4 1/2 per cent in both 2005 and 2006. Nonetheless, this represents a marked slowdown, with US growth projected to slow by 1/2 percentage point this year, and both Japanese and UK growth slowing by more than I percentage point relative to 2004. It also marks a growing divergence in growth rates within the Euro Area. Germany dipped into recession in the second half of 2004, but showed a strong recovery in the first quarter of 2005. Portugal also recorded a recession in the second half of 2004, but expanded only modestly in the first quarter of 2005. Italy, the Netherlands and Austria continued to decline in the first quarter. Italy, Belgium, Greece and the Netherlands are projected to slow sharply in 2005 as a whole relative to the previous year, while we see a mild acceleration in Germany driven by exports. World trade growth is expected to remain strong, with growth of 6.3 per cent projected, but will lose some momentum relative to 2004.
The rise of global growth above trend has continued to put upward pressure on the oil price, which has risen more rapidly than anticipated for the last several quarters. This has implications for the inflation outlook, and we see average OECD inflation rising to 2 per cent this year and 2.3 per cent in 2006. Recent exchange rate developments have reinforced inflationary pressures in the Euro Area, and our medium-term forecast for inflation in the Euro Area has come up by about IR percentage point per annum, to 1.8 per cent.
Chart 1 shows nominal effective exchange rate movements in the US, Japan, the Euro Area and Canada. While the US dollar remains weak relative to its level in 2001-2002, it has strengthened by about 3 per cent since the beginning of the year. The euro and Japanese effective rates have both come down by about 5 per cent over this period. The Canadian effective exchange rate, however, has continued on an upward trend, and is now more than 20 per cent higher than at the start of 2003. This has dampened the inflation outlook in Canada, which is forecast to hover at around 1 1/2 to 1 1/2 per cent per annum throughout our forecast horizon.
The readjustment of exchange rates will alter the projected pattern of world inflation. Model simulations on NiGEM suggest that a 5 per cent fall in the euro against the dollar raises Euro Area inflation by 0.2 to 0.4 percentage points a year in 2005 and 2006, whilst it reduces inflation by 0.2 percentage points in the US. However, the dollar effective exchange rate remains 12 per cent weaker than its level at the start of 2002, while the euro effective rate is 23 per cent higher. Despite the recent rise in inflationary pressures in the Euro Area, longer term exchange rate realignments coupled with capacity constraints in the buoyant US and weak wage pressures in the Euro Area will continue to allow a significant inflation differential of about 3/4 percentage points a year between the US and the Euro Area from 2007 to 2011.
Rising Oil Price
The price of Brent crude currently stands at over $56 per barrel, and our underlying assumptions see the oil price roughly 15 per cent higher on a permanent basis than anticipated in our last forecast. …