Goldman Sachs’ analyst Arjun Murti started the ball rolling by predicting oil prices at more than $200 (Rs8,640 today) a barrel and other analysts are now falling over their feet trying to play catch up with him. Legendary M&A (mergers and acquisitions) predator and billionaire hedge fund manager T. Boone Pickens says that oil prices will go to $150 a barrel this year. Is it speculation? Is it the result of strong growth in countries such as China and India? Or is the spike in oil prices the result of tight inventories and a fall in supply relative to demand, as a recent report from the International Energy Agency suggests?
It’s probably a combination of all three factors. Those who say that oil prices are in bubble territory, pushed up by liquidity unleashed by the US Federal Reserve, argue that China’s appetite for energy is well-known and should have been factored into oil prices a long time ago and mere “fundamentals” cannot explain the spurt from $100 a barrel on 2 January to the current price of around $130 a barrel.
On the other hand, those who argue that this is a supply problem, point out that surely the Saudis would have been only too keen to pump more oil at current prices and the fact that they haven’t done so is an indication of supply problems. But the speed of the rise certainly suggests that speculative funds have flowed into oil. Whatever be the reason, there’s little doubt that these high prices will have an impact on both growth and inflation.
That concern with growth and inflation also comes through clearly in the minutes of the last meeting of the US Fed. “Members were... concerned about the upside risks to the inflation outlook, given the continued increases in oil and commodity prices and the fact that some indicators suggested that inflation expectations had risen in recent months,” the US central bank said. The Fed also reduced its projection for 2008 growth to 0.3-1.2%, down from the 1.3-2% growth it forecast three months back. That revelation took its toll on the US equity markets and pushed the dollar down, as the Fed Fund futures signalled little or no chance of a further cut in interest rates at the Fed’s next meeting scheduled for 25 June.
There’s a conundrum here. All these years we’ve been hearing of how the developed countries have proved to be immune to a rise in oil prices and several reasons have been trotted out to justify why. The theory was that oil consumption as a percentage of gross domestic product has fallen, which is true. But another reason why high oil prices didn’t matter so much was because growth was so strong in the economy. Now that growth is faltering, rising oil prices are a danger.
Economists who have studied the oil shocks of the 1970s and early 1980s also point out that one reason why the US may not face stagflation now is because wages are no longer “sticky”—unlike during the 1970s, when heavily unionized workers were able to hike wages in tandem with inflation and thus pushing up costs further, they can’t do that now. But the problem is that inflation is being imported to the US on account of a weak dollar and because costs are also rising rapidly in exporting countries such as China. And finally, monetary policy has been very loose to combat the credit crisis, which again can fuel inflation. To cut a long story short, if inflation persists (and it’s quite possible that, if speculation is driving oil prices up, the bubble may burst suddenly), then the US may not cut rates any more and the next move may even be some tightening.
That’s not good news for the markets. The bounce in the markets that we’ve been seeing in the last couple of months, despite weak economic data, is almost entirely the result of the Fed increasing liquidity.
During the bull run of 2003-07, there were several occasions when even a hint of higher interest rates was enough to scare the markets. The first time it happened was in May 2004, when rumours first started floating that the US Fed was about to start tightening. Coincidentally, it was also a time of great political uncertainty in India—with a communist-backed government coming to power and the combination of economic and political risk sent the Sensex reeling. The next big fall occurred in May 2006, when central bankers were spooked by a resurgence of inflation on the back of rising crude and commodity prices. Nor was market aversion to inflation and higher interest rates a feature of the last bull run alone. More than a decade earlier, in 1994, emerging markets fell sharply as the Fed tightened monetary policy and funds flowed back to the US.
Last Thursday, the Fed fund futures market was pricing in a 70% chance of the US central bank tightening rates by 25 basis points by October and a 25% chance that the rate would go up another 25 basis points to 2.50% by the end of the year. The problem this time is that policy may have to be tightened even though growth is nowhere as robust.
For India, with a weaker currency, a high fiscal deficit, rising interest rates, slowing growth, relatively high valuations and political uncertainty, there’s not much reason for a revival of investor interest.
Worse, with the government using strong-arm tactics to keep inflation down, it’s the next government, after the elections next year, which will bear the brunt of these measures, and inflation could move up sharply next year. The bears are set to be in the driving seat for quite some time.
(Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at email@example.com)