Threat of oil price spike is on a par with eurozone debt crisis, ITEM warns

6:14AM BST 10 Apr 2012 By Angela Monaghan

http://www.telegraph.co.uk/finance/newsbysector/energy/oilandgas/9194325/Threat-of-oil-price-spike-is-on-a-par-with-eurozone-debt-crisis-ITEM-warns.html

The Ernst & Young ITEM Club said that should heightened political tensions in the Middle East push the price of oil to $150 (£94) a barrel from its current level above $120, the Government would also be forced to borrow more and there would be a greater risk of an early interest rate hike.

The risk of a further spike is being taken very seriously by the Bank of England, whose governor Sir Mervyn King has already warned publicly that disruptions to the supply of oil from Iran or Nigeria would likely push inflation up.

Andrew Goodwin, senior economic advisor to ITEM, said the threat posed to the UK economy by an oil price spike was now "on a par" with that posed by the eurozone debt crisis. "The eurozone is still very much a live issue and I certainly wouldn't write it off yet but the oil price spike has been the new threat from the beginning of the year," he said. "Were political tensions in the Middle East to escalate, you could easily see a further oil price spike."

He said that given so much of it is sentiment driven, even the fear that the Strait of Hormuz – which carries a third of the world's oil seaborne cargos – could close would be enough to cause a major spike.

ITEM has calculated that if oil prices rose to $150 a barrel in May and stayed there until the end of 2013, the price of unleaded petrol at the pump would rise to £1.60 a litre before the end of this year.

Under this scenario, inflation would average 3.7pc this year – well above the Bank's 2pc target and above the Office for Budget Responsibility's 2.8pc forecast. "This would make life very tough for households, with inflation likely to comfortably outpace wage growth yet again," said Mr Goodwin.

The Bank has forecast that inflation should fall below 2pc by the end of the year, but rising food prices as well as rising oil prices pose an increasing threat to that forecast. According to the British Retail Consortium, annual food inflation jumped to 5.4pc in March, from 4.2pc in February.

Mr Goodwin said that in "normal circumstances" such an oil price spike would trigger a recession in the UK, but one-off factors this year would probably see of the threat of a double-dip. He said that any negative impact on growth of the extra bank holiday for the Diamond Jubilee would likely be unwound in the third quarter, in which growth should also receive a boost from the Olympics.

"Without that [in the event of an oil spike] the UK would certainly be likely to see at least two negative quarters of growth."

Unemployment would rise above the psychologically crucial 3m mark to average 3.07m next year, which would "really bring home" to people the severity of the situation. The jobless total currently stands at 2.67m.

On monetary policy he said the Bank would probably try to "ride out the storm" as higher oil prices pushed up inflation, arguing that the spike was likely to be temporary. As such, it would justify keeping interest rates at the historic low of 0.5pc.

"If it became entrenched, that's when you start getting into problems. If there was a wage reaction, the Bank would likely come under pressure to act, which would have further negative implications for growth."

ITEM thinks more quantitative easing is unlikely in any event, but certainly so under the oil price spike scenario.