Get ready for a prolonged slowdown in the major industrial economies. If Brent crude oil prices stay substantially above $100 per barrel, the economies of the US and Western Europe will almost certainly struggle in the next few months.

 

At no point in the last five years have US manufacturing and the wider economy managed to expand strongly when international oil prices have been above $100.

 

In every case, prices above $100 have been associated with a loss of momentum as the Institute of Supply Management's (ISM) composite manufacturing index has fallen back towards the 50-point threshold dividing expanding activity from a contraction.

 

This analysis is fairly crude and little more than a restatement of the familiar view that growth slows when the cost of oil in consuming countries (the "oil burden") climbs much above 4 percent of GDP.

 

It uses Brent rather than US crude prices (also known as WTI) because seaborne, internationally traded Brent drives the cost of gasoline in the US and around the world.

 

Rising oil prices boost input costs and squeeze incomes for firms and households, as well as heightening uncertainty and deterring spending on big ticket items.

 

The impact is rarely immediate. It takes time for the full impact of rising prices to be realised by consumers and businesses - several tank refills and months worth of operating costs before they appreciate the full hit.

 

While the analysis is simple, it helps pinpoint the threshold at which high prices start to have an adverse impact on economic growth.

 

Some analysts prefer to express oil's impact in terms of the rate of change rather than an outright price level. University of California Professor James Hamilton has famously analysed slowdowns caused when oil prices surge above the previous peak set over the last one to three years.

 

On almost any timescale, current prices do not qualify as a Hamiltonian oil shock because Brent still remains below the record closing high set in July 2008 ($146) as well as more recent peaks in April 2011 ($127) and March 2012 ($126).

 

Even so, there is compelling evidence that prices above $100 have been associated with a loss of economic momentum.

 

It suggests the Hamiltonian focus on rates of change should be supplemented with an emphasis on absolute price levels.

 

At least in the current environment, it seems the major industrial economies struggle when prices rise much above $100. It is no accident that Saudi Arabia identified $100 as its target price earlier this year.

 

Leading oil analysts usually downplay the tension between high oil prices and GDP growth. Oil prices are framed as an investable "asset class" and a source of increased earnings for oil exploration and production companies rather than an input cost for other businesses and burden on consumers. More often high prices are framed as a consequence of strong demand and a healthy economy.

 

The framework is intended to convey the idea that it is possible to have high oil prices and strong growth. In practice, that looks difficult. In the past, the International Energy Agency (IEA) and others have identified $100 as the threshold above which prices enter the "danger zone," which looks about right.

 

It is important not to be too doctrinaire about the threshold concept. The US and other economies do not suddenly come to a juddering halt when prices rise from $99 to $101. But the further prices rise above $100 and the longer they remain there, the bigger the hit to the economy, all other things being equal.

 

One of the unfortunate side effects of quantitative easing (QE) is that investors tend to respond by bidding up oil prices - undercutting some of the stimulus intended by policymakers. In the United States, both the first round of QE in 2010/11 and the second round launched in 2011 were associated with temporary oil price increases.

 

The recent round of oil price rises illustrates the cruel conundrum. Oil prices have risen, in part, along with expectations that the Fed and the European Central Bank will provide further stimulus in the next few months, coupled with increasingly bellicose rhetoric in the Middle East. But the rise in energy prices risks undercutting the intended stimulus effect.

 

If past experience is anything to go by, the recent rise in Brent prices to well over $100 per barrel will, if it is sustained, lead to strong headwinds in the US and European economies within the next 3-4 months, ensuring that they continue to struggle through the end of the year.

 

Of course, this time might be different. Perhaps the economy will weather price increases more successfully than before. But no one has presented any convincing evidence for it. It seems much more likely that the recent rise in prices will eventually burn itself out by inducing another economic slowdown. - Reuters