James Pethokoukis

The Great One, Larry Kudlow, on the rise in oil prices:

In any event, I side with clear-eyed Wall Street forecaster John Ryding, who believes the $10 or so oil-price hike will reduce real growth by only one-quarter of a percent while adding a like amount to inflation. Ryding expects 3.5 percent growth this year.

Historically, a combination of spiking oil prices and an inverted Treasury yield curve signaling ultra-tight Fed money are precursors to inflationary recession. This has pretty much held true for the last six economic downturns. But right now, the oil spike is modest and Fed money printing is ultra-easy. The yield curve is steep and upward sloping, with long-term rates 350 basis points above short-term rates. This argues against recession right now.

And let’s not forget: Corporate profits remain very strong, an extension of the Bush tax cuts is helping the economy grow, and the one-time payroll tax cut may help cushion the oil shock. So at the moment, barring a blowup in Saudi Arabia, the economy will survive.

Of course, as Larry hints, the risk is if that $10 turns to a sustained $20 or $30. Then you are chopping a point off GDP growth, assuming a linear relationship between oil prices and GDP growth. At some point, that relationship breaks down and the damage being done gets far worse. The airline industry, for instance, does not seem to operate real well at $140 a barrel oil, as became clear in 2008. Even the current price levels are hitting profitability:

The airline industry will earn almost 50% less this year than in 2010, as fast-rising oil prices pummel the sector’s profitability.

The International Air Transport Association has now downgraded its airline industry outlook for this year to $8.6 billion from the $9.1 billion it estimated in December. This is a 46% drop in net profits compared to the $16 billion earned by the industry last year.

IATA raised its 2011 average oil price forecast to $96 per barrel for Brent crude, up from $84 in December. This will increase the industry fuel bill by $10 billion to a total of $166 billion.

Andy Xie paints a dire scenario:

Central banks around the world have released massive amounts of money in response to the current financial crisis … But the proposition that a weak economy means low inflation is false. The stagflation of the 1970s proves it.

This round of monetary growth has mainly fed speculation, not credit demand for consumption or investment. Speculation has reached a dangerous point with the oil price threatening to reach triple digits again. Its implications for inflation may spook the central banks to raise interest rates quickly and trigger another crash.The excess money supply has created a new liquidity bubble.

The resulting asset inflation (stocks and bonds in developed markets and everything in emerging markets) has stabilised the global economy. The current equilibrium is one on a pinhead. The hope for strong economic recovery led by emerging economies raises investor optimism – and asset prices. This eases pressure on corporate balance sheets, spurs property production and boosts consumption through the wealth effect, making the hope self-fulfilling in the short term.

A rising oil price threatens to derail this recovery. It can trigger a surge in inflation expectation and a major crash of bond markets. The resulting high bond yields may force the central banks to raise interest rates to cool inflation fears. Another major downturn in asset prices would reignite fears about the balance sheets of global financial institutions, leading to new chaos.