At the time of publication, oil prices had risen by £15 since the previous forecast. This box, from our March 2011 Economic and fiscal outlook, considered the potential economic implications, including the short-run effects on inflation and household consumption as well as possible longer-run effects on potential supply and the equilibrium capital stock.

Since the publication of the November 2010 Outlook, the sterling price of crude oil has risen by just over £15. Oil price futures, which we use to forecast the oil price, have increased by £15 in the short term and £10 in the medium term. Increased demand from fast growing emerging markets like China may account for part of this increase, but recent spikes in the oil price also reflect unrest in the Middle East and North Africa.

An oil price shock can affect the output of net oil importing nations, like the UK. For example, a higher oil price will tend to reduce real household disposable income, thereby reducing household consumption. The magnitude of the output loss depends on factors like oil intensity of the economy, the scale and persistence of the price shock, pre-existing inflationary pressures and monetary policy credibility. The impact varies substantially between countries, with income being redistributed from oil importing to oil exporting economies. Overall, the impact on world output is thought to be negative. The IMF has estimated that a 100 per cent increase in the price of crude oil, caused by a reduction in supply, lowers global GDP by around 1.4 per cent at the trough.a

We estimate that the recent increase in the oil price will increase UK CPI inflation by around 0.5 percentage points in 2011, relative to our November forecast. All else equal, this implies a reduction in the growth of real household disposable income of 0.4 percentage points and a reduction in output growth of around 0.2 percentage points relative to our November forecast. Of the downward revision to our forecast for output by 2015-16, a little over a quarter can therefore be attributed to the increase in the oil price since November. Further movements in the oil price, in either direction, could be expected to have proportionate effects.

Persistent changes in the real oil price can affect the economy’s supply potential if they affect the rate of capital accumulation. A key consideration is the extent to which any change in the oil price is transitory or permanent. A temporary spike in the oil price might be expected to have very little lasting impact. On the other hand, a permanent increase in the oil price may reduce potential output if it affects the equilibrium capital stock.b

It is too soon to assess whether recent increases in the oil price have affected or will affect the economy’s long-run supply potential. In the event that the increase in the oil price is both persistent and has an effect on potential supply this will tend to reduce the size of the output gap. In such circumstances we might expect to observe evidence of a smaller degree of spare capacity than expected.

a IMF, (2007), ‘Spillovers and Cycles in the Global Economy’, World Economic Outlook.

b Work undertaken by the interim OBR suggested that a permanent exogenous increase in the real oil price of 20 per cent may reduce trend output by around 0.3 – 0.5 percentage points.