How rising oil prices could affect eurozone potential output

Prepared by Julien Le Roux, Bela Szörfi and Marco Weißler

The recent rise in energy prices constitutes a significant supply shock, which could therefore also have an impact on the potential output of the euro area economy. Based on the assumptions used in the June 2022 Eurosystem staff macroeconomic projections, oil prices in US dollars over the period 2022-2024 are expected to be around 40% higher than their pre-period levels. -COVID (2017-19).[1] Expressed as a percentage, the increase in oil prices since 2019 is less than the shocks of 1973 and 1979 (Chart A).[2] Moreover, the increase observed between 2003 and 2008 proved to be of a greater magnitude than the current increase. The nature of the current oil price increase – largely a supply shock related to supply bottlenecks and the war in Ukraine – is more comparable to the shocks of the 1970s than those of the 2000s, when the demand for oil played a major role in the rise in the price of oil. fossil fuel prices.[3] Since the current rise in energy prices, and oil prices in particular, reflects supply-side factors, it could also affect potential output and the output gap, with implications for pressures inflationary. This box describes the channels of impact and uses elasticities estimated on historical data to highlight the risks to potential output resulting from the current rise in energy prices.

Table A

Annual relative change in crude oil prices in US dollars

(index = 1 in the year before the shock)

Sources: Bloomberg and ECB staff calculations.
Notes: This graph shows the relative change in the price of oil, expressed in US dollars, for the five years preceding and following each exogenous shock, where t0 represents the year preceding the oil price spike. For the 2020 shock, the price of oil is based on the June 2022 Eurosystem staff macroeconomic projections, which are based on oil futures prices as of 17 May 2022.

Regarding the channels of impact, economic theory suggests that, under certain conditions, permanent changes in oil prices can be negatively correlated with each of the determinants of potential output.[4] The capital stock is mainly affected by two opposite effects. First, the price of oil itself as an input into the production process can be seen as a component of the user cost of capital and can influence investment decisions. Second, the price of oil is negatively correlated with the degree of utilization of the capital stock and therefore with the rate of depreciation. Overall, in both cases, if the elasticity of substitution between oil and other intermediate inputs is greater than one, there is a negative relationship between oil prices and the existing capital stock, hence potential output. An increase in the price of oil reduces total factor productivity, since higher oil prices lead to the obsolescence of oil-intensive production technologies and therefore to a decrease in the value added of production. Moreover, the increase in transport costs resulting from the increase in oil prices could lead to a reduction in the incentive to specialize and therefore a reduction in productivity growth. The impact of rising energy prices on labor market trends depends on the extent to which workers’ wage demands adjust upwards. A rise in the price of energy initially increases costs and reduces corporate profits if nominal wages do not adjust. Restoring employment and profitability to their original levels requires a combination of lower nominal wages and higher output prices. In either case, real wages and the unemployment rate that do not generate wage or inflationary pressures (known as the unemployment rate without accelerating inflation or NAIRU) can be negatively affected and permanently alter labor supply. -work.

However, there is no clear empirical evidence that oil price shocks have a lasting effect on potential output. While Fuentes and Moder (2020) suggest that the 1973-74 oil embargo imposed by OPEC had a negative effect on global potential output only in the first year after the shock, which quickly reversed the subsequent years, some studies have found small effects on long-term real GDP growth.[5] Blanchard and Galí (2008) find, for a set of OECD countries, that oil price shocks have lost their importance as a source of economic fluctuations from the 1970s until today.[6] They argue that this stems from more flexible labor markets, improved monetary policy, and the fact that these economies are less oil intensive than in the 1970s. When the first oil shock hit the world economy in 1973, it it took about a barrel of oil to generate $1,000 of GDP at 2010 prices. Today, less than half that amount of oil is needed to generate the same level of production.[7] For the economies of the euro zone, this drop was probably even greater (Chart B) because their energy mix is ​​much less dependent on fossil fuels.

Table B

Net imports of fossil energy products

(kilograms per €1,000 of GDP – expressed in logarithm)

Sources: Eurostat, Insee, Istat and ECB calculations.
Note: The graph shows net imports of coal, coke, briquettes, petroleum, petroleum products and related materials, and gas, natural and manufactured, relative to GDP (in kilograms per €1,000 of GDP at 2010 prices).

Given the current rise in oil prices, the loss in the level of potential output in the euro area over the medium term can be estimated at around 0.8%. According to the elasticities derived from the macroeconomic models used to produce the Eurosystem staff macroeconomic projections, a 1% increase in oil prices would imply a fall in the level of potential output in the euro area by around -0.02% medium term. Assuming a permanent oil price shock of 40% – equivalent to the deviation of the oil price assumption used in the June 2022 Eurosystem staff macroeconomic projections from the mean for the 2017-20 period – the level of potential output in the euro zone should be revised downwards by -0.8% after four years (Chart C). This is a somewhat limited shock, which must be seen in the context of the cumulative increase in potential output, estimated by the European Commission at around 5.2% for the next four years. Furthermore, this assessment appears to be consistent with other estimates, as previous ECB work suggests an elasticity of -0.02 for the long-term elasticity of GDP to oil prices worldwide, which implies a similar effect of the current oil price shock in the long run. -term level of GDP.[8]

Table C

Distribution of the impact of the recent rise in oil prices on the level of potential output in euro area countries

(percentage deviations)

Source: ECB calculations based on elasticities derived from macroeconomic models used to produce Eurosystem staff macroeconomic projections for the euro area.
Notes: The scenario is based on the June 2022 Eurosystem staff macroeconomic projections, with the deviation from a counterfactual where the price of oil is set at the average for the period from the fourth quarter of 2017 to the first quarter of 2019. Around the euro area on average, the shaded areas represent the deciles of the impact of the current oil price shock on the level of potential output after four years, by country, for the nineteen euro area countries.

However, considerable uncertainty surrounds this analysis, particularly regarding the persistence of the shock and the policy responses. On the one hand, the magnitude of the shock is based on futures prices for the period 2022 to 2024, which can be very volatile. As a result, estimates of the magnitude of the potential output loss can vary widely. On the other hand, the monetary policy response to the inflationary pressure of a rise in oil prices can partially mitigate its persistence and reduce the medium-term effect on potential output by stabilizing the macroeconomic cycle and firmly anchoring the inflation expectations, thus limiting hysteresis effects. In addition, current technological and economic conditions differ significantly from those prevailing during past oil shocks. This situation may mean that production technology can adapt more quickly to changing input prices. In particular, for transport and household energy consumption, there are viable green alternatives that are much less dependent on oil.[9]

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