Limited impact of oil on inflation

The Greek economy has been able to weather a big rise in the international price of oil and the weakening of the euro against the dollar since the beginning of the year to grow by 3.5 percent in the first half compared to the same period a year earlier, according to preliminary estimates. But analysts and others are concerned about the impact of a sustained rise in the price of oil on the local economy, admittedly one of the most energy dependent in the EU. Although these concerns are justified – since the expensive oil is bound to have an adverse impact on inflation, output and the external accounts – they should not be magnified, provided higher consumer price inflation does not feed into wages. Wrong forecasts If the fluctuations in the price of oil have shown something in the last few years, it is not to trust the forecasts of analysts who are paid to forecast price moves. Why? They have consistently underestimated the price of oil. Finally realizing high oil prices are here to stay, they have scrambled to revise their forecasts to bring them closer to the yearly average. Figures show they have been upgrading their forecasts all year long since 2002. Many in the analyst community expected the 2005 price of West Texas Intermediate (WTI) to average some 35 dollars per barrel late in 2004. This means consensus oil price forecasts are often wrong, so it is very difficult to predict where the price of oil will be a few months from now. It is reasonable to assume the average price of brent and WTI oil will stay above $60 per barrel by the end of 2005. This is definitely not good news for the oil-hungry Greek economy but does not signal either a severe economic slowdown or a recession. The impact may be more noticeable on inflation rather than growth, at least in the remainder of 2005, given the country’s strong summer tourist season. Net oil imports accounted for 2.6 percent of Greek GDP (Gross Domestic Product) in 2003, much higher than in other eurozone countries, says EFG Eurobank’s economist Plato Monokroussos. He also points to Eurostat data showing crude oil and petroleum derivatives accounting for 57 percent of energy used in Greece, compared to some 41 percent in EU-15. Natural gas represents some 6 percent of the total, while renewable energy sources (such as wind and solar energy) hold another 4 percent or so. Even so, assuming the price of oil stays above $60 per barrel by the end of the year, this is going to add no more than 2-3 percentage points to the Greek consumer price inflation by end-2005. Of course, a lot depends on the government’s decision to let state-controlled utilities and transportation pass the cost of higher oil prices to final consumers. All indications show that these entities will be allowed to set their prices so as to pass a good chunk of their costs to users and bear a small portion of the burden themselves in the form of greater operating losses or smaller operating profits. Energy consuming sectors, such as chemicals, plastics metallurgy, should be hit harder but their contribution to inflation will depend on competition and the internationally set prices of the goods they produce. The sustained increase in the price of oil will indirectly burden the cost of companies in other sectors and may lead them to up retail prices to restore profit margins if demand for their products and services remains strong. Although one should expect a very mild impact on consumption spending from the oil tax, there is nothing to suggest at this point that consumer spending will falter in the remainder of the year. For this to happen, it would also take a marked deterioration in consumer and business confidence underlined by many layoffs and a sharp drop in asset prices, such as stocks and real estate. Is this likely? We do not think so, as long as the sustained rise in the price of oil does not continue and the euro does not depreciate significantly against the dollar. Impact on C/A What about the impact of higher oil import payments to the current account deficit and the economy? This is the factor which will produce the direct negative impact on GDP growth. The larger payments for oil imports are bound to widen the current account deficit and chop off a few points of this year’s expected GDP growth. Although the external sector has been a chronic drag on Greece’s economic growth, it was supposed to have a positive contribution this year because of favorable base effects with last year when Olympics-related expenses augmented the deficit. So, this may turn out to be the most direct source of negative impact on GDP growth from high oil prices, assuming tourist receipts do not rise enough to fully or partly alleviate it. All-in-all, it would be a surprise to see Greece’s GDP growth fall below 3 percent in the second half so as to drive the average growth for the whole year to 3.2 percent on the back of slower-than-expected consumer spending and higher oil import payments. GDP growth may ease to 3.3 percent or so in the second half but it will take a much higher oil price in euros to make it lower. The biggest threat to Greece’s economy from high oil prices is not the so-called first round effects on inflation and GDP growth which will be realized this year, assuming oil remains above $60 and the euro ranges between 1.19 and 1.25 against the dollar by the end of 2005. It is the potential damage from the second round effects which, normally, take a longer time to show up on prices and GDP growth and are generally smaller in size than the first round effects. If, however, collective bargaining fails to take this reality into account and wages are set high enough to compensate for the impact of high oil prices, then it is likely to turn a spike in inflation and a temporary drag in GDP growth into something more permanent. The high oil price should have a negative impact on Greece’s economy through higher inflation and slower growth this year. However, the effect of the few percentage points on consumer prices and growth does not threaten to derail the economy, assuming oil prices do not continue to head north and the euro keeps its ground against the dollar. The real threat to the Greek economy is to let high oil prices feed into the economy via unreasonably high wages next year and beyond.