Cost of oil forecast to drive down Irish GDP by 3% in 2011 - Ernst & Young - Ireland

Cost of oil forecast to drive down Irish GDP by 3% in 2011

Current tensions in North Africa and the sharp rise in the price of oil which has resulted will hamper economic growth in Ireland and across the eurozone according to forecast numbers issued today by Ernst & Young. In a research note released by the firm, Marie Diron, Senior Economic Adviser to the Ernst & Young eurozone Economic Forecast (EEF) unit says:

"Tensions in North Africa have intensified the rise in oil prices observed since the beginning of the year. With uncertainty over the political and social situation in the region likely to remain for some time, risk premia on oil markets will probably stay high for some time".

We have used the European Central Bank New Area Wide Model to look at the implications of oil prices staying high for much of this year and next. We find that if oil prices were to stay around $120/ barrel this year and next, eurozone GDP growth would be only around 1%. This would mean significant delays in what was already seen as a slow recovery.

Impact of rising oil price in Ireland - GDP to fall 3% at current $120/barrel

EFF confirms that if oil prices were to stay at $120/barrel, Ireland's GDP is forecast to fall by nearly 3% this year and rise by only around 0.5% in 2012. With oil prices at $150/barrel Irish GDP would continue to falling by 0.6% in 2012.

EFF comments that rising oil prices will impact the Irish economy in several ways. 

Diron comments "The first and immediate impact is higher transport and heating costs. Energy accounts for nearly 10% of households’ expenditure in Ireland. So a rise in energy prices quickly raises monthly outgoings. Since transport and heating cannot easily be cut back, this means a smaller amount left to spend on other goods and services.

Similarly, higher oil prices add to companies’ production costs and forces them to either cut back on other spending (e.g. new equipment or advertising) or to cut production.

Higher production costs are also passed on through the production chain and, typically after one to two years, result in higher prices of all kinds of goods and services that further dent households’ budgets. Given the current weak labour markets, employees would be unlikely to recoup the higher prices in higher wage increases and would therefore face losses in purchasing power, which would result in lower consumption.

Moreover, by cutting growth in the eurozone’s trade partners, higher oil prices would also have a negative impact on Ireland's export performance."

Likely ECB response to rising oil prices

EEF confirms that In this scenario, the European Central Bank may assess that higher energy prices for a protracted period raise inflation risks to unacceptable levels (inflation would average around 3% this year and 2.5% next year) and raise interest rates earlier and faster than we currently envisage. This would compound the negative impact of higher oil prices on economic activity.

Diron comments "In the event that tensions in the Middle East escalate and that oil prices move to $150/ barrel, the eurozone would be on the brink of recession and the number of unemployed would remain above 16.5 million.

In such a scenario, fiscal consolidation would be significantly hampered. As a result, the risk of renewed turmoil on sovereign debt markets would rise. A default by at least one peripheral country would be seen as increasingly likely. Moreover, the banking sector would be pressurised  even further with the possibility of new bailouts by the government.

Chances are that tensions would spread rapidly between eurozone countries given the size of cross-border exposure of banks. In such a scenario, the eurozone would likely go back to recession. With little room for manoeuvre on the fiscal and monetary policy sides to buffer the negative economic impact, the outlook for the region would turn very bleak for several years to come."

nb Baseline forecast used a figure of $85 per barrel

GDP = Gross Domestic Product
CPI = Consumer Price Index