Oil prices are surging again, close to $69 dollar a barrel this morning. After reaching a peak above $70 a barrel following the "Katrita" hurricanes of the summer of 2005, oil price fell to the low 60s in the fall and winter of 2005 as the summer peak season of high oil demand passed and as the release oil from the petroleum strategic reserves of the U.S. and Europe helped to calm energy markets. But in recent weeks oil prices - and gasoline prices - are sharply up again driven by several factors including the political tensions in Nigeria where supplies, production and exports are impeded by a growing civil war; the rising tension between the U.S. and Iran on the issue of nuclear proliferation; and the incoming high energy demand season of spring and summer. Since last fall I had predicted that tight capacity conditions - together with rising tensions in Iran and Nigeria - would bring back oil prices to the peaks of 2005. Also, structural conditions in the oil market remain tight as further supply and capacity increases are constrained by limited investment in unstable oil producing countries such as Iran, Iraq, Saudi Arabia, Russia, Venezuela, and Nigeria while demand is still growing at a good pace given sustained global economic growth. Thus, even leaving aside that fact that meteorologists now predict another banner hurricane season in the U.S. this summer, oil prices are likely to drift towards $70 or above and likely to stay at those high levels for the rest of the year. With tensions in Iran and Nigeria rising and no near term resolution of these geopolitical tensions (and some meaningful probability of worsening of such tensions), oil prices are headed further higher.

Thus, the main economic and policy issue is: if oil prices drift towards $70 a barrel and stay close to such levels for the rest of 2006 (let alone drifting higher), what will be the consequences of such high oil prices for the U.S. and global economy, both in terms of growth and inflation? One important observation before we try to answer this question: it is not just oil prices that are rising but also other energy prices and other commodity prices. Thus, while I will concentrate on the effect of high oil prices, everything I argue would be reinforced if other energy and commodity price also increase due to supply constraints.

Many observers - including myself and the IMF - predicted in 2004 and later that high oil prices would lead to a U.S. and global economic slowdown; but such a slowdown actually did not actually materialize. Such growth slowdown did not occur for several reasons: the oil and commodity price shock was driven by more by higher global demand rather than by a supply shock; U.S. and advanced economies are less dependent on oil than in the 1970s and 1980s; the recycling of petrodollars - via high oil exporters current account surpluses and excess savings - kept global long rates lower than otherwise and thus stimulated consumption and investment demand in oil importing countries; monetary policy remained very easy in the G7 (in the U.S. until late 2004; in the Eurozone and Japan until very recently) thus helping growth; asset and housing bubbles driven by low short and long term interest rates sustained demand and investment in many advanced economies; in China and other countries high oil prices did not lead to higher oil/energy retail prices because of price controls; many oil importing countries - especially the U.S. - reacted to the oil shock as if it was only temporary, thus not adjusting consumption and savings to the higher oil price level; and, finally, in the US in 2002-2004 a very loose policy stance with easy money, easier fiscal policy and a weaker dollar stimulated economic activity. On the inflation side, the spike in oil, energy and commodity prices did not lead to an increase in US and global core inflation rates. Again, the reasons are several: less structural dependence on oil and energy; globalization keeping non-oil import prices low; stable and credible low inflation monetary policies; sluggish growth of labor costs - in part due to globalization - that kept a lid on overall production costs.

One may also note that the peak in oil prices - above $70 - in the summer of 2005 was very temporary with oil prices falling towards the low 60s in the fall-winter of 2005. Thus, the potential stagflationary shock of oil at $70 was dampened by its transitory nature.  The relevant issue now is, thus, whether a renewed increase in oil prices to a level close or above $70 - that is sustained for the rest of 2006 - would have a larger effect on global economic growth and global inflation. My answer to this question is yes: if oil prices were to drift towards $70 and stay there for the rest of 2006 - as I expect they may given the arguments presented above - the effects on global growth and inflation would be more serious and significant than the effects of rising oil prices in 2004 and 2005.

The reasons are as follows:

First, average oil prices in 2004 were in the mid $40s and even in $2005 they averaged in the mid $50s (as the $70 peak was very transitory); oil close to $70 for most of 2006 would imply another 30% increase in oil prices relative to the already high 2005 average levels. The stagflationary effects of oil at $70 - and possibly higher if the tensions with Iran rise further - in terms of lower real incomes and higher production costs would be more significant than with oil at $45 in 2004 or even $56 average as in 2005. Indeed, recent reports that manufacturing costs are soaring - for example in the UK - as oil and commodity prices are hitting new highs.

Second, the factors that sustained economic growth in the U.S. in 2004-2005, in spite of high and rising energy prices, are fizzling away. The Fed increased the Fed Funds rate from 1% to 4.75% and is likely to bring it to 5% at its next FOMC meeting in May; the bond conundrum is also shrinking as long rates are now starting to increase towards the 5% level; most signals from the housing market are showing a cooling of the housing bubble as shopped-out and saving-less consumers are now being hammered by higher interest rates on both their ARM and fixed rate mortgages; while the job markets is still producing jobs, real wages for median and mean households are falling  while consumer confidence is depressed for low income workers - while surging for the wealthy - as increasing income inequality is rightly making workers worried about their future prospects in an economy where globalization is increasing while the social safety net is shrinking. Thus, the last thing that a shopped-out consumer with negative savings and increasing debt and debt service ratios needs now is higher oil and energy prices at the time when the housing bubble is fizzling out and the purchasing power support provided by mortgage equity withdrawals is also fizzling out. The U.S. consumer will not survive unscathed the triple whammy of a housing bubble flattening, oil prices surging and short and long term interest rates rising. One should also notice that, in addition to the direct stagflationary effects of an oil shock and the induced policy response, higher oil prices driven by geopolitical tensions - such as an increased probability of a military confrontation with Iran - could have an independent effect on consumption and investment demand via their likely effects on consumer and business confidence.

Third, one does not need to predict a collapse of consumption to forecast a sharp U.S. growth slowdown: with consumption representing 70% of GDP, even a slowdown of consumption from a 4% growth to a moderate 2% growth would be enough to slow down U.S. economic growth from its potential and actual 3.5% growth rate to a rate closer to 2% by the end of 2006 and into 2007. Could other components of aggregate demand pick-up if private consumption were to slow down? Highly unlikely: net exports are still deteriorating in the U.S.; government consumption growth is modest; housing investment would be actually falling in this housing slump scenario; so, only non-residential investment could help, but in a scenario in which consumption growth is falling why would firms want to invest much more into greater production capacity?

Fourth, would Asia and Europe "de-couple" from a U.S. economic slowdown? Several observers argue that a U.S. economic slowdown should not necessarily need to a significant economic slowdown in the rest of the world. The argument is twofold: in Asia there is now enough momentum in domestic demand and growth in countries such as China, Japan, India and South Korea that, in spite of strong trade links, a U.S. economic slowdown would not have major effects on Asian growth. Similarly, some argue that the economic recovery that is being experienced by the Eurozone could be sustained by domestic demand, rather than just net exports, and thus sustain Eurozone growth in spite of a U.S. slowdown.  These arguments about a "de-coupling" of the rest of the world from the U.S. could make sense if the U.S. slowdown was driven only by a fizzling out of the U.S. housing bubble that slows down consumption growth. But, if in addition to a housing-driven slowdown, the U.S. economy were to be also hit by another oil shock, it is hard to believe that the rest of the world could de-couple from the U.S. There are three main reason why such decoupling would be unlikely: a) a U.S. slowdown would be sharper if it is triggered by both housing and an oil shock, thus leading to greater trade transmission effects to the rest of the world; b) a oil shock directly hits negatively oil importing countries regardless of its effects on the U.S.; and regions such as the Eurozone, China and Japan depend on imported oil much more than the U.S. does and are thus more vulnerable than the U.S. to an oil shock; c) a sustained oil shock would have some inflationary consequences that would force central banks in the U.S., Europe and Japan to tighten monetary policy more than they currently plan to and more than financial markets are currently pricing. Thus, it is hard to believe in a de-coupling if the rest of the world is hit by a triple whammy of a U.S. slowdown, stagflationary high oil prices and tighter monetary policy.

Fifth, the oil shock would have inflationary consequences that would force central banks to tighten monetary policy more than currently priced by the financial markets. And this additional monetary tightening will slow down global growth further than otherwise. So far, the oil, energy and commodity shock of 2004-2005 has had effects on headline inflation but not on core inflation; the reasons why inflation has not increased have been discussed above. But oil at $70 for a protracted period of time would have more meaningful effects on core inflation than in the recent past for a number of reasons: this oil shock would have more aspects of a supply shock - as being driven by geopolitical tensions - than the demand increase of the last two years; growth is recovering in Japan and the Eurozone, as it did since 2004 in the U.S.; thus the oil shock would hit the advanced economies at a time when labor markets are tighter than in 2004 and output gaps smaller; there is evidence of labor market tightness, wage pressures and inflation concerns even in China; until now firms could absorb the previous oil shocks via reductions in their high profit margins and via slack labor markets; but from now on it will be harder for firms to squeeze further profit margins: more likely some pass-through from costs to prices would occur; finally, the pass-through from headline to core inflation would be greater if oil prices rise above $70 and stay there for a while in a persistent manner. Here we do not need to assume a sharp and unrealistic increase in headline and core inflation. It is, for example, enough for core inflation to increase from around 2% to 2.5%, a modest 50bps increase, for the Fed to be forced to tighten by an extra 50 to 100bps more than currently expected by the markets at unchanged core inflation; ditto for the ECB and the BoJ. Note that, while the Fed could react to a U.S. slowdown that is only driven by housing with a halt to its tightening (say stopping at a 5% Fed Funds rate), the Fed would be forced - based on a standard Taylor Rule - to hike the Fed Funds rate at least to 5.5% and possibly as high as 6% if core inflation were to increase towards 2.5%. The last thing that the new Fed Chairman Ben Bernanke could afford, in the face of rising core inflation, would be to be labeled as an inflation dove or wimp. Similarly, any increase in core inflation in the Eurozone and Japan would be met by an increase in the policy rates more than otherwise priced in, as the concerns about increased inflation triggered by such persistent stagflationary shock would dominate any concern about a growth slowdown that such a shock entails.

Given all the arguments presented above, I thus argue that a persistent spike in the price of oil above $70 in 2006 would have stronger effects on growth and inflation - in the U.S., other advanced economies and oil importing emerging markets - than the oil shocks of 2004-2005. What could derail my forecast that an oil shock will meaningfully affect the global economy in 2006? First of all, of course, if oil prices do not surge to a level around $70 and/or do not stay around such a level for the rest of 2006, any U.S. slowdown would depend more on developments in the housing markets than developments in the oil markets; in that scenario, the rest of the world could partially de-couple from a housing-driven U.S. slowdown. Second, a $70 oil shock that leads oil exporters to further increase their savings and current account surpluses could lead to a further reduction in long term interest rates that - everything else equal - would benefit aggregate demand in oil importing countries. But any such effects on long rates are likely to be swamped by the direct inflationary effects of the shock and the monetary tightening by the policy authorities in the G7. Third, a really robust and synchronized global reflation in the G7 countries and emerging market economies - driven by investment demand, trade and consumption - could sustain global growth in spite of rising oil prices. But, again, it is highly unlikely that the U.S. and the rest of the world could withstand - with little effect on global growth - the triple whammy of a housing-driven U.S. slowdown, high oil prices and tighter monetary policy.

In conclusion, if oil prices rise above $70 and stay there for the rest of 2006, it is highly likely that the U.S. and global economy could experience a serious growth slowdown and a policy meaningful increase in core inflation. Of course, if the tension with Iran were to seriously escalate and a military confrontation becomes highly likely oil could easily spike above $100 and we would experience a global recession rather than just a global slowdown. But this latter scenario is a totally different story that may have to be picked up and fleshed out at some later stage....