Sun, Jan 03, 2016 - Page 9 News List

This year will light a fuse on an imminent economic explosion

Oil prices, China and Brazil are likely to influence the international economy’s drift toward another crisis next year, but the real pain is likely to come later

By Larry Elliott  /  The Guardian

Economic forecasting is a mug’s game. One thing that has been learned from the financial crisis and Great Recession is that even those equipped with the most sophisticated models get it wrong, sometimes spectacularly.

So it is with both humility and trepidation that I will try to fulfill the promise made two weeks ago and make predictions for what is going to happen this year. In all honesty, the future is unknowable and anybody who says otherwise is lying.

So, with that health warning, here is what I think might happen.

At some point, a recovery built on booming asset prices, weak growth in earnings and rising personal debt is going to lead to another huge financial crisis. However, not in the next 12 months.

Instead, this year would be the year of living dangerously, a year of papering over the cracks, a year of buying time before all the old problems resurface.

Here is why. The big story of the past month has been the collapse in oil prices, which has taken the price of crude back to levels last seen in 2004. This has two beneficial effects for the international economy: It provides additional spending power for the households and businesses that consume energy, and it bears down on inflation.

There is always a bit of a delay between oil prices falling and spending going up in response, in part because people want to be sure that the lower costs are going to stick. However, it is now 16 months since crude began its decline from an August 2014 peak of US$115 per barrel and there is a good chance they would fall a bit further from their current level in the mid-US$30 per barrel range. With no sign that the OPEC oil cartel has the political will to agree to production curbs, it is quite possible that prices could fall below US$30 per barrel in the early months of this year.

The impact of that would be to keep inflation lower than any of the world’s major central banks are anticipating. Policymakers at the US Federal Reserve, the Bank of England and the European Central Bank (ECB) insist they “look through” rises and falls in oil and other commodity prices, and make their interest rate judgments on the basis of what is happening to core inflation, which excludes energy and food costs.

However, it is harder to raise interest rates if, for whatever reason, inflation continues to undershoot official forecasts. More importantly, there is evidence a fall in inflation caused by cheaper oil has an effect on wage bargaining.

When, in the pre-crisis years, UK inflation was regularly hitting the government’s 2 percent target employers used to offer pay awards of 4 percent. Now that inflation is zero they see no reason to offer more than 2 percent.

That matters, because central banks are looking for signs of wage inflation picking up as a result of years of steady growth and falling unemployment. If wage inflation does not go up, there is less of a reason to raise the cost of borrowing.

So, prediction number one for next year is that both inflation and interest rates are likely to stay lower for longer than currently anticipated.

The US Fed raised interest rates for the first time in almost a decade earlier last month, but is likely to be extremely cautious about its next move. The Bank of England is also likely to hold off from its first move. Cheap money would boost both borrowing and — for a time — growth.

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