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Global Economic Brief: Saudi Attack Sets New Growth Threat

Oil prices have soared in the aftermath of the attack on Saudi oil refineries, but the real risk to oil supplies and the world’s economies lies in the possibility that the crisis could escalate.

Until this past weekend, it appeared that a supply shock in the form of protectionist trade policies might be a key factor in driving the next downturn. However, the drone attack on Saudi oil facilities raises the threat of a new supply shock that could play a role in reducing economic activity. The Kingdom shut down about half its productive capacity, or about 5% of global output. This entails a loss of output of about five million barrels per day. On Monday, the price of crude oil soared, rising nearly 13%, down from an initial 20% jump earlier in the day.

Ira Kalish
Ira Kalish

The Saudis say the damage to oil producing facilities is substantial and will require several months to bring production back to normal levels. However, some of the shutdown of facilities was precautionary, so there will be a modest increase in production quite soon. The Saudis indicated that they can release oil from their reserves, thus enabling them to stabilize prices.

Additionally, President Trump said that he has ordered the release of Strategic Petroleum Reserve emergency oil supplies “if needed,” a move intended to calm nerves and stabilize prices.

Along with soaring oil prices, safe-haven assets increased in value, with yields on U.S. Treasury bonds falling and the price of gold rising. Equity prices fell modestly. Investors are evidently not yet concerned that this crisis will precipitate a recession, for two reasons: First, the global economy is already decelerating and not operating at full capacity, so the loss of a modest amount oil production capacity is not likely to create huge bottlenecks. Second, this price rise is nothing compared to past episodes that did contribute to recessions. In 1973, at the time of the Arab oil embargo, the price quadrupled. In 1979-80, following the Iranian revolution, the price doubled. Unless this crisis worsens, it seems unlikely that the impact on economic activity will be large.

However, should the attack evolve into a worsening crisis producing a larger and more prolonged disruption of Middle Eastern oil production, it could have grievous consequences for the global economy, especially if there is a war involving Saudi Arabia and Iran. Moreover, such a war might drag in the U.S. and even Israel.

On the other hand, it is worth noting that the world economy is less dependent on Middle Eastern oil than in the past. Since the 1970s, production has risen substantially in many other locations, including the U.S. with its stunning increase in shale oil output. The world is also less reliant on oil than in the past, leaving the global economy better able to withstand disruption than was true 40 years ago. The amount of oil consumed per dollar of real GDP is about half what it was in the 1970s.

One major area of uncertainty is the path of U.S. policy in the region, especially as the administration has threatened military action against Iran. Another uncertainty relates to the potential impact on the Federal Reserve’s interest rate policy. It is widely expected that the Fed will cut the benchmark interest rate by 25 basis points when its policy committee meets later this week. What is uncertain is how the Fed will communicate its longer-term intentions.

The oil price shock creates a new dynamic for the Fed. A rise in prices can both create higher inflation and cause slower economic growth. Back in the 1970s, this was known as “stagflation.” It creates an especially challenging task for the Fed which is charged with minimizing both inflation and unemployment. The failure of the Fed to fight the inflationary impact of the oil price shocks in the 1970s contributed to historically high inflation.

The ECB Eases Monetary Policy

With the eurozone economy apparently at risk of recession, the European Central Bank (ECB) cut its benchmark interest rates from -0.4% to -0.5 % and resumed quantitative easing, at a rate of 20 billion euros per month, as expected.

There is concern among some investors as to how much monetary policy easing will help the eurozone economy. Further, it can be argued that historically low interest rates have distorted financial markets, contributing to asset price bubbles, hurting bank profitability, and not necessarily doing anything to boost economic activity when borrowing costs are already low.

Indeed, outgoing ECB president Mario Draghi said that monetary policy alone might not be sufficient to revive growth in the eurozone. He joined the IMF and many business leaders in urging governments of the eurozone nations to initiate fiscal easing.

The reasoning: with negative bond yields in several eurozone countries (including Germany and France), and with Germany currently running budget surpluses, there is plenty of room for governments to borrow money and spend it on infrastructure. Governments would be borrowing free of charge and investing in capital that would likely have a positive return in terms of increased economic growth. In that sense, governments would likely avoid a ruinous increase in debt. However, there remains little evidence that governments, especially in Germany, are thinking in such terms.

Meanwhile, eurozone industrial production continued to decline in July, down 0.4% from the previous month and down 2.0% from a year earlier. This was the ninth consecutive month in which industrial production declined from a year earlier. Year-over-year industrial production was down 5.3% in Germany, 0.3% in France, 0.7% in Italy, and up 0.3% in Spain. Clearly, Germany is the problem.

Japanese Consumers Remain Calm Ahead of Sales Tax Increase

In October, Japan’s government is planning to increase its national sales tax from 8% to 10%. It had been widely expected that households would spend with abandon before the tax increase. The fact that this has not happened has led to both optimism and pessimism. On the one hand, the fact that household spending has not surged means that, after the tax increases, a collapse in spending is unlikely. This bodes well for avoiding a recession.

On the other hand, some observers worry that households are not especially keen on spending at all, problematic given that the government is hoping that household spending will help to offset the weakness of investment and exports.

There are some good reasons why household spending will not be as volatile compared to the last such tax increase in 2014, First, fresh food is exempt from the increase. Second, the government has created incentives for spending on durable goods meant to offset the impact of the tax increase. Third, the government is instituting incentives for consumers to engage in cashless payments, which could fully offset the tax increase. It could be the case that households, aware of these various incentives, are not especially concerned about the impending tax increase.

Still, the incentives will be only temporary and, eventually, households will feel the full effect of the tax increase. The government has been keen to implement this tax increase, to improve the long-term viability of Japan’s obligations to its elderly citizens. With an aging population and, consequently, rising pension and healthcare costs, the government worried that, absent a tax increase, the already large budget deficit would balloon.


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