Oil prices loom as a 'clear and present danger' on the minds of the world's finance officials arriving in Washington for the annual meetings, according to IMF chief economist Raghuram Rajan.
After an upgraded Hurricane Rita devastated refineries in Louisiana and Mississippi, the price of crude leapt yesterday to a new historic high of $70.85 a barrel to underline growing concerns.
Analysts say prices are unlikely to retreat far, even after the hurricane abates. Officials from the IMF, World Bank and IFC all stress the potential dangers to the global economic system.
The linkage between oil prices and inflation is growing stronger, Rajan argues. That could accelerate rises in interest rates, threatening to hit global growth and to puncture asset bubbles.
High oil prices have had a limited impact on growth thus far, 'in part because prices were driven up by unexpectedly strong demand growth,' Rajan said at a briefing yesterday. 'Yet, increasingly it is not news about unexpected demand, but news about supply shortfalls and potential future shortages, especially of refined products, that is driving price increases.'
The fuel price issue is now 'adversely affecting confidence and with economies closer to capacity may create stronger inflationary pressures. Oil price increases are thus unlikely to be benign going forward and they are already affecting emerging markets and developing countries.'
Rajan urged governments to 'pass through oil prices in order to curb consumption, and to adopt conservation measures.'
The IMF's World Economic Outlook, published yesterday, also warns of the danger that 'inflationary expectations could become much more marked' as a result of soaring oil prices, and that this 'raises the risk of a sharp rise in interest rates and adverse supply-side effects.' The danger that this in turn could puncture housing price bubbles in various parts of the world is a 'real possibility,' said Rajan.
The inflation risk is likely to worry officials more than the oil price itself, because of its potential impact on interest rates and on equity and housing markets, as well as on growth. The issue is likely to figure at the G7 finance ministers' meeting on Friday, one finance ministry official told Emerging Markets.
'The reason why oil prices are so high is the limited supply capacity in producer countries,' Hans Timmer, Manager in the global trends group of the World Bank's Development Economics Department told Emerging Markets.
This spare capacity has fallen from around 6 million barrels a day to nearer 2 million b/d, in the space of the past few years. 'So, there is limited capacity to absorb shocks,' he says. But there is plenty of capacity for further shocks given the unstable situation in the Middle East, terrorist threats and natural disasters.
The low oil prices of most of the past two decades discouraged new exploration.Even if current oil prices should stimulate fresh exploration and production - although oil companies are not anxious to undertake to much until they are certain that these prices will persist - it will take around five years for new supplies to come on stream, suggested Timmer.
There is fresh investment taking place in refining capacity, but that affects the price of gasoline rather than crude oil. Therefore, the best we can expect is 'volatility' in oil markets and the worst is much higher prices if fears of shortage