Andrew Sentance discusses why low inflation should not delay interest rate rises
The big economic development last year was one that no major economic forecaster had predicted - a dramatic drop in the crude oil price. Brent crude has fallen to between $50 and $60 a barrel after being up at $100 or more for more than three years. The prospect of oil prices continuing at around current levels marks a significant change to the world economy.
The most noticeable impact so far has been on Russia and the value of the rouble. The other very large oil producers in the world - Saudi Arabia and the United States - should be less heavily affected. The US is a net oil importer, so consumers will gain more than producers lose. Saudi Arabia has very strong financial reserves to weather the storm.
However, a number of other economies are vulnerable to the downward shift in oil prices - including Nigeria, Venezuela, Angola, Iran and Iraq. Many governments in oil-producing states have expanded their budgets on the basis of strong oil revenues. If current low prices persist, or fall further, they face serious financial challenges.
Looking at the world economy as a whole, low oil prices should be beneficial for growth and consumer spending in the major advanced economies - US, Europe and Japan. It should also benefit consumers in large emerging market economies that are net oil importers - notably China and India. That boost comes partly through lower consumer prices.
Inflation is now negative in the eurozone and likely to be close to zero in the UK in the early months of this year. But it won't continue at such a low level. Later in the year, the fall in petrol and energy prices will start to drop out of the annual inflation rate calculation. And the boost to consumer spending and growth in oil-consuming countries like the UK will put upward pressure on other costs, including wages.
We have already seen how lower oil prices can boost growth and push up inflation. The dramatic fall in oil prices in the mid-1980s was one of the factors that helped to spur the robust growth of the late 1980s and 1990s. But the experience of the late 1980s also provides a warning. If consumer-driven growth is too strong, then wider inflationary pressures will start to emerge.
Forecasters are already starting to be more optimistic about growth in the major western economies. The US is expected by many to grow at more than 3% this year and projections for UK growth are also moving closer to the 3% mark. The European Commission has revised its projection for growth in the EU upwards, citing the oil price as one of the factors underlying its more positive view.
One factor contributing to UK inflation in the late 1980s was the upward pressure on wages and other business costs created by falling unemployment, skill shortages and capacity pressures. At present, we're not seeing these pressures on the same scale as in that Nigel Lawson boom. But the UK economic indicators are moving in the same direction. Unemployment has been falling steadily for the past three years and the number of vacancies recently passed the previous peak recorded in early 2008. Reports of skill shortages are rising and, although wage increases have been very subdued since the financial crisis, they are starting to move upwards.
Another lesson from the 1980s is that the short-term impact of a lower oil price on inflation can send misleading signals to interest rate-setters. Lawson initially cut interest rates after the mid-1980s oil price fall, encouraged by low inflation. But when the economic boom was in full swing in 1988, he had to raise them sharply - to a peak of 15%. We see a similar reluctance to raise interest rates from the Monetary Policy Committee (MPC) at present, with low inflation being cited as one of the reasons for delay.
But if the MPC waits until the inflation warning signs in the economy are flashing amber or red, it may not have the luxury to pursue its preferred policy of moving the interest rate slowly and gradually. As we saw in the 1980s, a delay in adjusting monetary policy can mean that the interest rate lever needs to be pulled more aggressively to get the economy back on track in the future.
We should welcome the impact of lower oil prices in pushing down inflation and boosting consumer spending. It provides support to growth across the Western world and helps the struggling economies in the eurozone. But a lower oil price should also bring closer interest rate rises in better-performing economies like the UK and the US. If these rate rises are delayed too for long, a sharp hike may well be needed in the future.
Dr Andrew Sentance is a senior economic adviser at PwC, and a former member of the Bank of England MPC