Central Banks and the Wrinkle With Falling Oil Prices

Despite all the headlines recently about central banks, the most important development in the world economy these days is the sharp—and apparently persistent—drop in the price of oil. It’s down nearly 40% since June.

This is the best thing to happen to the global economy since we discovered we weren’t tumbling into Great Depression 2.0. It occurs at a moment when the world, especially outside the U.S., sorely needs a little growth tonic. Of course, it’s going to hurt oil-producing countries—the good guys (Mexico) and the bad guys (Venezuela, Russia)—but nearly all major developed and emerging-market economies are oil importers and will benefit. The falling prices are like a big taxcut: It gives consumers more money to spend on other things and reduces the cost of production for business.

When oil prices fall because demand is weak, that’s a sign of trouble. When they fall because there’s more supply, that’s a reason for optimism. JPMorgan Chase economists estimate that this year’s decline in oil prices is 55% supply (the result of increased oil production in the U.S. and North Africa, and Saudi Arabia’s decision not to curtail OPEC production to support prices) and 45% demand (most of that the slowdown in China and other emerging markets.) In other words, more good than bad–and the effects of the good parts have yet to be fully felt.

JPMorgan estimates that lower oil prices would boost the pace of overall global growth by 0.7 percentage points over the next two quarters. For emerging markets, the impact is bigger because they get a boost from lower oil prices and another boost from stronger demand from developed economies. Christine Lagarde, managing director of the International Monetary Fund, said during the WSJ CEO Council meeting that IMF forecasters figure the drop in oil prices will add 0.8 percentage points to developed-country growth next year. In the euro zone, the simultaneous decline of the euro and oil prices help offset other factors that are depressing growth. In the U.S., says  Jan Hatzius of Goldman Sachs, lower oil prices will offset the negative effects of a higher U.S. dollar (which hurts U.S. exporters.) Domestic oil producers will be squeezed, but the rest of us are winners.

“The $30 per barrel oil price drop since the first half of 2014, resulting in a near $1 per gallon gasoline price decline, could add 0.2 to 0.4 percentage points to the growth rate of [U.S.] GDP,” Columbia’s Jason Bordoff and Harvard’s James Stock wrote last week. “This overall beneficial macroeconomic effect is smaller than it was a decade ago because net imports have fallen and because the drop in oil prices may retard the growth of nonconventional oil production.”

On balance, falling oil prices are welcomed by the world’s major central banks, but there is a wrinkle. Lower oil prices are good for growth in the U.S., Europe, and Japan. But they’ll also reduce the headline inflation rate at a time when the central banks, particularly the Bank of Japan and the European Central Bank, are struggling toraise the underlying inflation rates in their economies and keep public and investor expectations of inflation from falling. That involves a lot of psychology as well as economics. While central bankers often look beyond volatile food and energy prices to gauge the underlying inflation rate, they know that ordinary consumers don’t. “It’s important that [the drop in oil prices] … doesn’t get embedded in inflation expectations,” the ECB’s Mario Draghi said last week.

Although lower oil prices are good for business and consumers, “what makes it a bit more complicated this time round is that we already have an environment of very low inflation and the lower oil prices are just going to reinforce deflation fears,” Belgium’s central banker, Luc Coene, told reporters recently. ”That could partly neutralize the positive effects.”

True, but ask any central banker if he or she would prefer rising prices instead.