In a speech today at Durham University Business School, MPC member Ian McCafferty considers the factors contributing to the recent fall in the oil price, the impact on inflation and its likely persistence and how, given this analysis, UK monetary policy should respond.
Ian argues that as with the oil price falls seen in 1985 and 1998, ‘there is merit in examining recent oil price developments, and the implications for the outlook for the oil market, through the prism of hog-cycle theory.’ As with the livestock markets hog cycle theory is based on, short term elasticity of oil supply is low but the longer-term elasticity substantially higher. As a result the main adjustment to price falls comes from changes in investment plans which in turn impact productivity and supply in the longer term.
This analysis shows that ‘the lag in the supply response means that for a while, even after the initial price fall, supply continues to exceed demand, such that inventories continue to build.’ As the market balances and inventory levels fall back ‘the market tightens and prices begin to rise, encouraging supply to recover. But here too, there are noticeable lags – first, it will require a period of higher prices to encourage producers to commit to new investment, and geographical, geological and political issues mean that the lead time to new supply is relatively lengthy.’
Ian suggests that ‘we can expect oil production to ease in the second half of the year’ and for demand for oil to increase due to the net positive impact to global demand, estimated by Bank staff to stand at around 0.8%, which in turn will support greater demand for oil. ‘Overall, it is reasonable to assume that, by the end of 2015, supply and demand for oil will be coming back into balance, although inventories will remain high for a further period. This should translate into more stable yet still relatively low prices,’ though further out ‘prices might be expected to recover’[…] bankofengland.co.uk
