Why high oil prices are not squeezing us more

Indeed, why isn’t the rise in prices we have seen already having more of an effect? For those who were brought up on the rule of thumb that every 10% rise in oil prices led to a 1% drop in global growth, the resilience of economic activity in response to sky-high oil is surprising.

Those rules of thumb are, however, no longer relevant, according to the National Institute of Economic and Social Research. In January 2007, oil dipped briefly below $50, and futures markets pointed to a price over the next six to seven years in the $50s and low $60s. When the institute did its latest assessment, oil was above $100 and the curve suggested it would stay around that level.
Had it not been for that rise, America might have grown 2% this year rather than the 1.3% the institute expects. Growth in Europe and Japan would have been half a point higher. But in Britain, however painful the energy squeeze, the effect is calculated to be small, a mere quarter of a percentage point off growth (the smaller effect is because North Sea oil and gas production, while in decline, is still significant). The inflation effect is bigger, roughly a percentage point across all the advanced economies, but a far cry from the old days.

Ray Barrell, an economist with the institute, said the big change is that economies are less directly sensitive to oil prices than they used to be. The “energy intensity” of growth – the amount of oil, coal and gas needed to produce an increase in gross domestic product – has halved since the 1970s, reflecting greater energy efficiency and the shift away from heavy manufacturing.

Labour markets have also become more flexible, said Barrell, so workers accept temporary reductions in real wages when energy prices rise, while in the past they would have demanded compensation. The wage-price spiral used to mean expensive oil led to inflation, unemployment or both. Central banks now are under less pressure to act to head off the “second round” inflationary effects of dearer oil.

Life would be a lot easier if oil prices fell. So what will happen?

Sunday Times