Oil Prices Impact on Currency Rates and Economy
Changes in oil prices are a vital component for the global economy given the impact on both growth and inflation. There are also clear winners and losers in terms of economic impact which can lead to important currency-market opportunities, especially given cyclical elements in both oil prices and major economies.
In this article we will help you understand how the oil prices impact all currencies and all economies in the world (to a varying degree, of course). Like all other components of economy, oil prices are difficult to predict and difficult to amount their precise impact, but learning the basics can help one make better decisions in when transferring foreign currency abroad.
Major oil importing economies damaged by higher oil prices?
The major global economies overall are substantial net importers of crude. When oil prices move higher, there is a net decline in purchasing power within the largest economies. At the retail level, fuel prices increase which has a direct negative impact as increased spending on energy triggers weaker discretionary spending.
Higher energy prices also lead to caution over investment given uncertainty surrounding the outlook. There is, therefore, a negative impact on growth within the global economy.
In contrast, a decline in oil prices will boost net consumer spending and support overall GDP growth.
Current Oil Prices:
Inflation implications are substantial
As well as growth, changes in oil prices have an important impact on inflation. Energy prices have a substantial weighting in consumer prices indices given the importance for consumer spending and shifts in energy costs will have a direct impact on headline inflation.
There are also important secondary effects as higher energy prices trigger upward pressure on costs within the industrial and transport sectors.
In this environment, there is the risk that an inflationary spiral develops as cost increases are passed on to the consumer sector. Higher headline inflation also tends to put upward pressure on wage settlements and inflation expectations which can reinforce upward pressure on prices.
Summary: Declines in oil prices will lower headline inflation with sharp fluctuations in prices complicating monetary policy.
Extent and duration of moves are crucial
The scale of oil price rises and the duration of increases are key factors in determining the outlook for global economies and potential policy responses. A relatively short-lived increase in prices tends to have only a limited impact, but substantial and extended gains in energy are much more important.
Global central banks consider underlying inflation to be more important and will tend to ‘look through’ short-term changes in inflation driven by changes in oil prices. It is, however, much more difficult to ignore sharp and sustained increases in prices, especially given the potential impact on inflation expectations. In 2018, currency volatility has been at record high also because of major and sudden oil price movements.
Central banks and governments can worsen the situation
Central bank and government responses to changes in oil prices and inflation are also key elements in determining whether individual and global economies can weather sharp shifts in prices.
Given that higher energy prices increase inflation, there is pressure to raise interest rates in response to an increase in oil prices. Higher interest rates, however, tend to dampen activity further which can push economies into recession, especially as there will already be net damage from higher energy prices.
Although central banks also monitor underlying inflation, there is an important risk that any move to raise interest rates in response to higher inflation will amplify an economic downturn
Similarly, there is also a risk that lower energy prices will lead to complacency over underlying inflation and central banks can set monetary policy too loose for the underlying economy which leads to financial instability.
Fiscal policy is also a key element with governments of exporting countries needing to pursue counter-cyclical policies to smooth economic cycles. Reckless spending during an upturn will substantially increase the risk of a steep downturn when energy prices decline.
Sharp variations within Individual economies
In broad terms, the impact on economies will depend on whether countries are net importers or exporters of crude. Countries that are net exporters benefit from higher oil prices while countries which are net importers are damaged by higher oil prices. The corollary is that exporters suffer economic damage when oil prices decline and growth tends to be stronger when oil prices increase.
The impact tends to be magnified by the impact on government finances as revenue declines when oil prices come under pressure. An unsustainable boost to fiscal spending in times of high oil prices is particularly dangerous as governments are then unable to respond by increasing spending in a downturn
Cyclical trends are a feature
There is inevitably an important cyclical impact as higher prices will increase the risk of global recession and weak demand will pull oil prices lower again. Low prices will also eventually trigger a global growth recovery.
There is, therefore a solid case for selling the Canadian dollar when prices are very high and buying when prices weaken sharply, and take similar actions with other currencies based on their import/export status as well as the duration and magnitude of movements in the oil prices.