Oil prices caused the recession, redux; and what it could mean

Updated: A paper by James Hamilton argued that the recent oil price shock was a key factor putting the US into recession – at least between Q4 2007 and Q3 2008. It received a lot of coverage, including some from us.

Merril Lynch’s London-based commodities team has joined the club:

In our opinion, the Great Recession of 2008-09 is the result of a simultaneous
shock of surging energy prices and mounting credit problems (Chart 8). The crisis was precipitated by the collapse of Lehman Brothers, but it was the oil price spike that killed emerging market growth. We firmly believe that the world economy would not have contracted so sharply in 4Q08 without the tremendous oil price spike to $150/bbl that occurred in 3Q08 (Chart 9). [Scroll down for charts]

But what’s interesting is their analysis of what this could mean. The central problem of this crisis, they say, is “a fundamental misallocation of capital”.

Loose monetary policy led to bubbles in emerging markets and US housing. So what is happening now?

The large increase in gobal liquidity has resulted in sharp increases in EM equity
and commodity prices. But any impact of commodity price increases on headline
inflation will not likely come until 4Q09, as oil prices are only a fraction of what
they were last year. In the meantime, capital flows are heading into emerging
market equities at full speed, as global investors recognize the severe limitations
to economic growth in OECD economies.

They say a rapid increase in prices could put an embryonic recovery at risk:

Our economists believe that a jump in oil prices to the $70-80/bbl range could start to pose some meaningful risks to economic growth in OECD countries. Meanwhile, our economists see the risks to growth in the $90-100/bbl range for EMs.

Of course, we are still some way off those price points, and as they note in their report, some Opec members are already beginning to relax their adherance to quotas. As ever, all eyes will be on the next Opec meeting, this Thursday.

Update: Riccardo Barbieri, chief economist at Banc of America Securities-Merrill Lynch, expands on the theme in the ‘View of the Day’ column in tonight’s FT. $70 or $80 a barrel would not at all be dire for advanced economies, he says (somewhat reassuring as Saudi oil minister al-Naimi today mentioned a $75 target). But it’s all about timing:

“As long as prices rise only moderately from here – say, revisiting the $80 a barrel level by year-end, this would not pose severe risks for the advanced economies, while the emerging ones would be able to tolerate even higher levels, say, $100, in due course,” he says.

Mr Barbieri says the main issue is whether oil’s rise is part of the “reflation trade” seen in the equity and credit markets, or whether it re­flects a significant increase in oil demand.

“It seems that the oil market has mostly responded to improving expectations concerning the timing of the recovery more than to an actual pick-up in demand,” he says. “The oil futures curve has flattened significantly in recent weeks, with late-2009 and 2010 contracts rising a lot less than the front ones.”

Barbieri says that the Opec producers would not likely allow prices to jump too quickly:

“Given the precarious state of the global economy, it makes sense to us to expect that Saudi Arabia would boost production if prices moved up too quickly,” he says.

Volatility is in no-one’s interests; nor is a worsening recession.


Related links:

James Hamilton’s 70-page report is here (PDF), and the examination of the 2007-08 recession begins halfway through.

If high oil prices are what caused the recession, then lower prices should… (FT Energy Source)
Was the US recession caused by the oil shock of 2008?
(FT Energy Source)
Further evidence on the influence of oil on the US economy
(The Oil Drum)
Can the oil shock alone explain the financial crisis?
(Atlantic)
Did the oil boom of 2008 cause crisis?
(WSJ)

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