Oil Prices Impact on Currency Rates and Economy

By Last Edited Aug 01, 2018

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 the 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

The 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

Canada

Canada's economy concept with canadian flag and money dollar currency golden symbol. Among the G7 economies, the largest impact is seen in Canada. When oil prices increase, there is a direct boost to the economy and there is also a positive impact on capital spending as companies boost exploration.

In contrast, a decline in oil prices has an important negative impact on the economy. The Canadian impact is magnified by the fact that most of the Canadian oil is produced from high-cost fields which quickly become unprofitable as prices decline.

Higher oil prices tend to strengthen the Canadian dollar while the currency weakens when oil prices come under pressure. When oil prices collapsed from late 2014, the Canadian economy weakened sharply and the Bank of Canada lowered interest rates to 0.5%. The Canadian dollar also came under sustained pressure with USD/CAD fx rate peaking above 1.4500.

There has, however, been a stronger trend over the past 18 months and the central bank has increased interest rates to 1.25% and the Canadian dollar is stronger than 2016 levels.

UK

The UK is only still a small net exporter of oil and there tends to be a very limited positive net economic impact from gradual increases in oil prices, but sharp increases are damaging.

Euro-zone and Japan

The Euro-zone and Japan are heavy net importers of oil and their economies weaken when oil prices increase sharply.

The Euro-zone impact was magnified in the last cycle by the fact that the ECB responded to higher oil prices in 2014 by raising interest rates. This had the effect of triggering notable demand weakness with a sharp downturn in growth.

When oil prices declined, Euro-zone inflation moved into negative territory and the central bank was then forced to introduce quantitative easing in order to ease deflation fears.

Overall, the yen and Euro tend to lose ground when oil prices increase.

US

There is a mixed US impact given the shifts seen over the past five years. Developments in fracking technology have enabled US producers to extract shale oil more effectively and at much lower costs than previously

There has been a sharp increase in domestic production to record highs. In this context, the US is now less sensitive to the impact of higher oil prices, but there is a larger impact from declines in prices, especially in Texas. Overall, the dollar implications are relatively neutral.

Emerging markets

Within emerging markets, Russia is a clear beneficiary from higher oil prices with a smaller positive impact on Mexico. In contrast, countries such as Taiwan and South Korea lose out from higher energy costs. China is also a major oil importer and higher energy costs will tend to undermine the economy.

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.

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