- Oil prices have declined by almost 50% since the summer. US gasoline pump prices have fallen by around 40% in this same period. The gains for US household disposable income should amount to around USD 170bn in a year, which is around 1% of GDP.
- On the other hand, energy producing firms are the main losers. Lower oil prices are already affecting their earnings and investments. Estimates suggest that the drag on oil-related investments would be around 0.2% of GDP in a year.
- As for the impact of low energy prices on inflation, core inflation, which captures the second round effects has been softening a bit. We think that the impact will wane by the end of this year as oil prices gradually increase. We maintain the view that the Fed will hike interest rates in June. We are relatively optimistic on GDP growth and we expect wage growth to firm. But given the uncertainty around the second round effects on inflation, there is a risks the Fed will move later.
Winners and losers from lower oil prices,…
On balance, the net gains from lower oil prices are expected to have a positive impact on the US economy. On the one side, consumers will benefit the most from higher disposable incomes, on the other side the fast growing energy producing firms are already feeling the decline in earnings from lower oil prices. In order for the US to maximise these gains and take full advantage of the opportunities that lower oil prices bring about, several factors have to fall into place. US consumers have to spend the extra disposable income and US energy producing firms will have to deal with the impact of lower oil prices in the most cost efficient way.
… but overall a positive for the US economy
We estimate that the net gains for the economy will amount to around 0.8% of GDP over a year, with some of the results already evident in the fourth quarter of 2014. Indeed, the US economy is already seeing consumption grow at the highest rate since 2006, while fixed investment growth has slowed down.
As for inflation, the impact on consumer prices is expected to be temporary. But there are downside risks related to the second round effects of lower oil prices on core inflation. These effects could materialise through lower production costs and/or lower expectations of future inflation.
Rise in household disposable income large…
Lower energy prices are expected to boost household disposable income. The impact on disposable income considering the 40% decline in gasoline prices is expected to be around USD 170bn in 2015, which is around 1% of GDP. US households consume around 135bn gallons of gasoline a year. The price is down about 40% from USD 3.50 a gallon in the summer to USD 2.18 today. This generates an annual saving of USD 178 bn a year. The pass-through of these gains to consumption spending will depend on several factors, including whether consumers think that the decline is relatively permanent, or whether they have preferences to pay down debt, and/or increase savings. In general, we think that the decline in oil prices will have transitory effects, but it is expected to last long enough to have an impact on consumer spending. In previous episodes of declining prices consumption has been boosted after two quarters on average.
…but how quickly will consumers spend?
Given the positive outlook for the economy and particularly the labour market, we don’t expect that households will use these gains to pay down debt or only increase their savings. We think that their permanent income flows will likely be used for this purpose. Consumer spending has already been boosted in the fourth quarter, expanding at an annual rate of 4.3%. The highest since the recession.
Drag on US energy producing firms to extend beyond this year
In the US, the impact of lower oil prices is not straightforward, given the growing importance of domestic energy producers. Currently almost 75% of total US oil consumption is supplied by domestic producers. Estimates suggest that a decline in USD 20 a barrel amounts to USD 60bn less in revenues for oil producers. Less revenues implies less capital spending. Mining capital expenditures comprise about 1% of GDP. In the past few months, energy producing firms have announced cost-cutting investments. The contraction of investment spending is expected to be around 0.2% of GDP in 2015, but the impact will likely extend beyond this year.
Impact of low oil prices on inflation will wane,…
We think that the impact of low energy prices on inflation will wane by the end of this year, but before that inflation and core inflation will remain low for a while. Indeed, core inflation has been slowing down somewhat in the past three months. In fact, core goods inflation has been slightly negative lately. But the weakness in core goods prices is not a recent phenomenon. Perhaps more troubling is that some measures of inflation expectations have declined. This could create uncertainty around the second round effects on lower energy prices inflation and the implications this could have for the Fed’s monetary decisions.
…but Fed is closely watching
Indeed, the rate hike lift-off is now especially sensitive to the inflation outlook. We find that the relationship between daily changes in oil prices and the market-implied fed funds rate at end-2015 has turned modestly positive. We think that given the transitory effect of the decline in oil prices and core inflation running around 1.5% yoy, this should keep the rate hike as scheduled for mid 2015. Meanwhile, prices of core services and shelter (rent) have been picking up lately, suggesting that there is some underlying upward pressure to core inflation. On top of this, the positive outlook for the economy will encourage spending, eventually lifting prices. In any case, Fed policy makers, still consider that inflation in the medium term is within the target range, which is what really matters.