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BT's Chief Economist, Chris Caton

Petrol Prices vs The Economy - June 2008

Well the Budget has come and gone, and not much is different. Share markets rose again in May, although not by much, and the US economy continued to send off mixed signals, thus enabling both the optimists and pessimists to maintain their views. I continue to think that there is worse economic news to come from the US, which will be a challenge for share markets.

The continued rise in oil prices was a feature of the month. At end-April, a barrel of West Texas Intermediate cost $116; in late May this price hit $135. Oil prices have doubled in little more than a year. There are those who ascribe all of the rise to “fundamentals” (that is, supply and demand), and there are fanciful forecasts out there that the price may hit $200 per barrel in relatively short order. Count me among the sceptics. Those who claim the price rise is all justified by fundamentals need to be able to identify exactly which fundamentals have changed so much in the past year. Did we not know a year ago that demand in the developing world was likely to continue to rise? Has there been any massive reassessment of the future supply of oil?

If (at least some of) the price rise is not due to fundamentals, then the next move may well be downwards. My personal view is that oil will trade at $100 per barrel before it trades at $150. This, incidentally, is the same forecast that I gave my audiences a year ago.

If oil prices are to retreat, then they will soon begin to dampen inflation, although we have not yet seen the peak effect on overall inflation of the rise to date. The rise in oil prices has, of course, reduced the real income of consumers. In the US, consumer spending is growing more slowly than at any time in the past 16 years, and “working families” are complaining vociferously about petrol prices in Australia, leading both sides of politics to look for means of alleviating the pain. If I am correct, and oil prices do fall, then this latest outbreak of “bad economics” will be halted before it can do too much damage.

Am I the only one who thinks that our politicians should be engaged in weightier matters than ensuring that everyone is free to drive the Tarago at the lowest possible cost? I don’t expect to win many friends by saying so, but we should be taxing petrol more than we are, rather than less.

The consumption of petrol is taxed in every developed country that I am aware of, and for good reason. First, there is an enormous amount of public infrastructure associated with petrol consumption. Why shouldn’t petrol users pay for that? Second, unlike most goods and services that we consume, the consumption of petrol imposes costs on others, mainly in the form of environmental damage and congestion. If petrol is untaxed, then we will use more of it than is socially optimal. In Australia, this tax burden is relatively small; I am aware of just two developed nations, the United States and Canada, that impose a lower tax burden. One can imagine that the present outburst of rampant populism on this issue could well lead to the “quarantining” of petrol when Australia gets serious about reducing carbon emissions. Were this to occur, greater cutbacks will need to be made elsewhere, and the consumer will suffer, with electricity prices, for example, being far higher than otherwise.

There is a further consideration. The “burden” of the increased cost of petrol is commonly exaggerated by stories of how many dollars it takes to fill the family car (imagine that, a problem exaggerated by the media!!). The chart shows the ratio of consumer spending on gasoline to total personal income. It shows that, as of the December quarter last year, this ratio was 2.8%. Data for 2008 are not yet available, but this share is still likely to be little more than 3%. Note that the share was higher for almost the whole time from the onset of OPEC II until early 1987. How can this possibly be true, given that the pump price is so high and, as I showed last month, the price of petrol relative to total consumer prices is at a record high, and about 30% higher than it was in the early-to-mid-80s? There are two main reasons. First, cars are more fuel-efficient than they used to be. Second, in the past 20+ years, our real incomes have risen, but we have not increased the distance that we drive nearly so much.

Petrol spending as a share of personal income Source: ABS

The Outlook for Interest Rates

Not much has changed on this front in the past month. The Q1 GDP accounts confirmed that the Australian economy has already slowed in 2008, but this is not (yet?) a problem. If we are to dent inflation, then the economy needs to grow at less than trend (probably 3-3.5%) for some time and, in particular, the unemployment rate is probably going to drift upwards. Bear in mind, too, that there are two massive sources of stimulus about to hit the Australian economy in the form of the personal income tax cuts and the huge boost to coal and iron ore prices, which is itself worth about 3% of GDP.

The June quarter CPI should again be ugly, both in headline and underlying terms, but the RBA should be able to argue that we’ve hit the peak (of at least 4.5%) in this episode, which will mean that it doesn’t have to raise rates further. But we are a long way from a rate cut.

Despite the protestations of some who should know better (including several ex-RBA officials), we cannot afford to be complacent about this outburst of inflation. Some time ago, central banks decided that economies functioned best if inflation were low and stable. Alan Greenspan had one of the best definitions of low inflation; it’s low enough when consumers, wage earners and businesses don’t take it into account in their decisions. We’re not there at present! The RBA’s forecast has inflation above the target range for the next two years, indicating that it will keep policy tight, but does not intend to tighten so much that inflation is improved quickly but at the cost of serious damage to the economy.

So assume interest rates stay where they are. And given that credit-market conditions have improved at least slightly, the banks are unlikely to raise the variable rate further of their own volition.

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