By Simon Louisson of NZPA
Friday 21st April 2006
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World oil prices this week hit a record $US74 ($NZ120) a barrel this week and the pain at home is only just beginning, especially if this month's recovery of the kiwi dollar proves only temporary.
"Barring a major change in the price of crude oil, household spending could be squeezed by around $550 million this year," said Westpac chief economist Brendan O'Donovan.
A litre of regular petrol now costs around $1.70 - a third up on a year ago and 50% above two years ago.
ANZ National Bank chief economist Cameron Bagrie said the rise in petrol prices is likely to do what nine interest rate hikes since the start of 2005 have failed to do - crimp household consumption.
"My suspicion is that higher petrol prices will be the trigger that will invoke the long-awaited consolidation within the household sector. They will start to rebuild stretched balance sheets.
"The big wild card is what it does to the consumer psyche because consumers are rife for a period of consolidation."
Households have been living it up largely because their house prices have been rising and they feel relatively richer. Fixed mortgages have immunised them from rate hikes although many of two and three year loans are now up for renewal just as petrol rises are starting to bite.
Bagrie believes the latest round of oil prices rises will materially affect growth, shaving 0.3% off this year's growth.
While Reserve Bank Governor Alan Bollard may be happy at the prospect of moderating demand, his job is to contain inflation, and higher petrol prices do the opposite.
This week's consumer price index showed inflation in the March year rose to 3.4%, driven largely by higher petrol prices and housing costs.
Inflation has now been outside the 1% to 3% target band for three quarters and questions must soon be raised about whether Bollard is doing his job properly.
Transport companies are already warning that they will have to push on costs to retailers and supermarkets. That's what's known as a second-round effect of petrol price rises.
"It's that cost-push inflation spiral that the Reserve Bank is very worried about because that threatens to unhinge inflation expectations," said Bagrie.
"There is a strong possibility of second-round inflation seepage - that will scare the bejesus out of the Reserve Bank."
It will be exacerbated by rising import prices due to the New Zealand dollar's 8% fall this year.
However, Bagrie believes competitive pressures in the economy will limit second round inflationary effects.
Company margins will get squeezed, which will in turn squeeze profits. Luckily, corporate New Zealand is in good shape with balance sheets robust after a number of good years.
The rise in oil prices will exacerbate New Zealand's already dire current account deficit. In the early 2000s New Zealand's oil products bill came to around $3 billion a year. In 2005 that rose to $4.5 billion and this year looks set to top $6 billion.
A Treasury official said that while the Government collects more gst from higher petrol prices, spending cuts elsewhere neutralise that.
Last year's budget stated oil prices were expected to decline from the then price of $US50 a barrel but Treasury saw them "considerably above their long-term average of $US20".
Government is affected similarly to consumers and households with costs for running services such as the police rising. Benefits are inflation-adjusted, so costs go up while the squeeze on company profits means corporate taxes diminish.
Treasury believes it is too simplistic to look only at higher prices to measure the effect on growth. Oil has risen because of strong demand and that has also helped boost prices for New Zealand's exports.
Indeed, what is different about the latest oil price surge from the mid-1970s shock is that global growth has galloped merrily along.
Oil prices have doubled in the past two years and tripled since 2002, yet global economic growth hit its fastest rate in 30 years in 2004 - at 5.1% and world growth remained above its long-term average last year at 4.3%. The International Monetary Fund this week hiked its 2006 growth forecast to 4.9%, the best since 1976 apart from 2004. At the same time it cut the forecast for New Zealand to 0.9% from 2.5% - the slowest in the OECD apart from Portugal.
"The resilience of Western economies to recent oil shocks has been remarkable," Andrew Oswald, Professor of Economics at Britain's Warwick University told Reuters.
James Hamilton, Professor of Economics at the University of California, San Diego, who has spent much of his career documenting the ups and downs of an oil-driven economy told Reuters he was sanguine about the latest rally in crude prices.
"Overall, the world economy weathered the 2005 oil price increases with less economic damage than I had been anticipating," he said. "That leads me to believe that $US70 oil is not, by itself, a cause for major alarm at this time."
Past oil crises were damaging because producer countries unexpectedly turned off the oil taps.
Today's problem is a "demand crisis" - caused by the breakneck pace of economic expansion in countries such as China, now the world's second biggest consumer of oil after the United States.
But the theory that a demand crisis is benign may be turned on its head if the standoff over the nuclear intentions of Iran, the world's fourth largest producer, escalates into conflict.
And while the rosy outlook for world growth will mitigate the macro economic effects of higher oil prices on the New Zealand economy, local households are still going to feel a considerable effect.
New Zealand will be stuck with the highest interest rates in the developed world as Bollard grapples to put the inflation genie back in the bottle.
Bagrie foresees two main effects locally.
"At the household sector, there will be a general belt tightening.
"Petrol is a necessity, so there is a low elasticity of demand, so if the price goes up, you have to take it on the nose. You just have to reallocate your spending. What is likely to be hit is luxuries."
Secondly, he expects companies' margins and bottom lines to be squeezed which in turn will make firms refocus on costs.
"That could imply some pretty significant decisions on the hiring and employment front."
While he is not predicting doom and gloom, Bagrie said the good days are behind New Zealand for the moment.
"We are going to be doing things pretty tough over the next 12 to 18 months. Slower growth and a persistent inflation theme will make for grumpy growth."
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