The slump in oil prices is a bad sign

published 11 August 2008

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It's like something out of a cheesy disaster movie.

Just when we thought all was lost, and the Western world was going to be consumed by recession, the mighty US market drags itself back to its feet. The Dow Jones jumped by more than 300 points on Friday.

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The rebound was driven by a slump in crude oil prices (partly down to a leap in the dollar), which has pundits on both sides of the Atlantic getting excited. Lower oil prices, means lower inflation, which means lower interest rates, they argue. And it also reduces one of the pressures on consumer spending.

So can the collapse in oil prices save the economy from recession? Sadly not. The rising oil price was a symptom, not a cause, of the unchecked global boom that lead us here. And the fact that it's falling now is merely a sign that we're already in the grip of a huge downturn

Why falling oil prices won't save the economy from recession

The main reason why falling oil prices won't save the global economy is that high oil prices were never the problem in the first place.

Oil prices rose for many reasons. Pure demand was one reason, as more and more people used less and less energy-efficient cars, more people took flights, more industries were set up, more goods were made, etc.

Supply was another, as low oil prices meant that oil companies didn't invest in finding more. That means it takes a while to catch up by the time prices have shot up far enough to encourage new investment.

And speculation has definitely played a role. The jury is out on the precise mechanism by which pure investment money has had an impact on oil prices, but it seems madness to suggest that you can pump all those extra billions into a market without having some effect on it.

At least two of these factors demand, and speculation have been driven to a greater or lesser extent by the availability of cheap money. Commodities have been turned into consumer goods in the East, which were then bought with borrowed money by the West. The East then used this money to build more factories to make more consumer goods, which the West then bought with more borrowed money, much of which also came from the East.

But the days of cheap money are gone. And so it seems, are the days of rocketing oil prices. A barrel of crude is trading below $120 now, after peaking at just above $147 earlier in the year.

None of the central banks is serious about fighting inflation

Now what's the good news? Well, a fall in the oil price might help to prevent the inflation problem from growing any worse, certainly. That'll allow central banks to cut interest rates, say the pundits, and we can then set the whole ball rolling again.

But the idea that central banks even care about inflation is a farce. The European Central Bank puts up the best front of all the major central banks, but none of them is serious about fighting inflation.

For example, by holding the base interest rate at 5%, while inflation keeps rising, the Bank of England has been allowing real interest rates to fall for months now. If Consumer Price Index inflation hits 5% as many analysts believe it will by the end of the year, we'll have our very own zero interest rate policy here in the UK.

Meanwhile, in the States, the Federal Reserve has already slashed nominal interest rates to 2%, which means that real interest rates have been negative for some time (headline annual CPI inflation in the US is standing at 5%). So central banks have been doing as much as they can to loosen monetary policy yet it hasn't helped matters.

The fact is that the oil price is falling because demand has slumped. As Forbes puts it, falling oil prices "suggest that the recession the US has so far avoided is well on its way, as consumers pull back from the spending spree that drove economic growth earlier this decade. A weakening economy will mean more layoffs, further pressuring already reduced spending."

For now, stock markets are focusing on the bright side. But sliding oil prices won't help any of the most troubled sectors both consumers and financial companies need to repair their balance sheets, so retailers can't expect to benefit from falling oil prices. Meanwhile, those companies which have been propping up the markets commodity-related stocks will also start falling back.

The problem facing the global economy right now is not a shortage of oil. It's a shortage of money, following an unsustainable glut. Whatever happens to the oil price it's not going to make that money start flowing again.

Turning to the wider markets

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UK shares were broadly flat again on balance, with the FTSE 100 index nudging up 12 points to 5,489. Miners dropped back as commodity prices eased, with Kazakhyms down 6.5%, Anglo American slipping 2.8% and Vedanta losing 4.9%. In contrast, Friends Provident rallied 5.6% on bid talk, while Thomson Reuters advanced 9% ahead of this week's results and Wolseley put on 6.3% "aided by disposal theories", said the FT. British Airways soared 8% on lower oil prices. BT gained 1.4% amid rumours of a tie-up with Deutsche Telecom. For a full market report, see: London market close .

Shares in Europe were better, as the German Xetra Dax edged up 0.3% to 6,562 and the French CAC 40 put on 0.8% to 4,492.

US stocks ended the week with a storming finish, making their first consecutive weekly gain since May. The Dow Jones Industrial Average jumped 302 points, or 2.65%, to 11,734, while the wider S&P 500 added 2.4% to 1,296 and the tech-heavy Nasdaq Composite gained 2.5% to 2,414.

Overnight the Japanese market rose 262 points, 2%, to 13,431, and in Hong Kong the Hang Seng tacked on 154 points, 0.7%, to 22,040.

This morning Brent spot was trading at $114, spot gold at $860, silver at $15.26 and platinum at $1,573.

In the forex markets this morning, sterling was trading down against the strong US dollar at 1.9155 but up against the euro at 1.2800. The dollar was firmer again, trading at 0.6682 against the euro and 109.96 against the Japanese yen.

And in London this morning, Guernsey-based property management group Mapeley has reported a second quarter loss after the value of its properties fell by £35.9m. Its properties are mainly leased to UK government departments.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.