Oil price fall to smooth path to rate cuts

The outlook for crude oil appears increasingly benign and will help policymakers in Asia manage inflationary pressures in the short term, according to leading economists.

The lingering shadow of high oil prices has recently added to uncertainty over the economies of Asia as regional inflation levels continue to rise despite mounting evidence of slowing growth in China and India.

Stubbornly high levels of headline inflation and evidence that price pressures continue to accumulate have raised questions over whether the policy response by regional central banks has been adequate.

So far policymakers’ hands have been tied as rising oil prices heighten inflation risk and prevent widespread monetary easing as any sudden change in oil prices could jolt Asian economies already grappling with increasing food prices.

However Julian Jessop, chief global economist at London-based Capital Economics, said he expected benchmark Brent Crude to end 2012 below $100 a barrel and closer to $95 before falling further next year to $85.

Prices have been kept high by ongoing tensions with Iran, while unrest in Syria, Sudan and Yemen has caused supply disruption elsewhere. With Asia so dependent on the strategically important Strait of Hormuz even the remote possibility of Iran blockading supply could be enough to add as much as $10 in additional risk premium, Jessop said.

But these factors have been offset by improving supply situation in Iraq and a renewed stream from Libya that will cause prices to drop back much further.

That will be a boost for China whose demand for oil is likely to remain high and increased 8.7% in the year to March according to Barclays Commodities Research.

Paul Gamble, chief economist and head of research at Jadwa Investment in Saudi Arabia, told Emerging Markets: “We anticipate oil prices will fall during the remainder of the year. The demand outlook remains fragile, not least because of the impact of high oil prices on economic growth.”

He said the diminishing threat from Iran would provide more flexibility to policymakers in Asia. “We think the most likely scenario is that an accommodation will be reached between Iran and its adversaries that will allow tensions to defuse, putting further downward pressure on prices.”

A drop in oil prices and the subsequent impact on inflation would provide greater flexibility for Asian authorities to deploy more aggressive macroeconomic policies.

One consequence is likely to be greater economic cooperation between countries to stem volatility in financial markets and reduce the influx of speculative funds.

The inextricable link between oil and the growth in Asia’s economies means that from a policy perspective, governments must be agile in dealing with inflationary risk.

With speculation that worse may yet be to come in the eurozone crisis, the Asian region could be damaged by the rapid reversal of capital flows as banks in Europe withdraw from the region.

Managing liquidity and inflation whilst simultaneously safeguarding against sudden systemic shocks will test the resolve of regional policymakers for some time to come.