When it comes to the impact of higher oil prices on economic activity and inflation, we must be humble. The main reason why is that the effects appear to vary over time. Going back to the 1970s, for example, when the first big oil shock occurred, most economists vastly under-estimated the importance of higher oil prices – mainly because they failed to take into account the interaction between weaker global demand and higher costs of production.

Thanks to their poor forecast performance at this time, much work was done during the second half of the 1970s and through the 1980s to increase understanding of the processes at work and improve the models used to gauge the impacts of changes in oil prices on the global economy. Somewhat surprisingly to many involved, the resultant frameworks then began to over-estimate the effects of changes in oil prices on both GDP and prices. Much of the literature during the early part of the noughties sought to explain why the "improved" models turned out such a poor performance.

More pertinent still to the current situation is the growing recognition that oil price expectations might sometimes 'change gear' – in the sense that, following a period when prices oscillate around a flat trend (leading people to treat both positive and negative surprises as one-offs), sometimes a sufficiently long run of price surprises in one direction can shift expectations such that both firms and consumers expect prices to continue rising/falling, rather than revert to their old trend level.

This non-linear sensitivity of the expected price level to the actual, as inflationary expectations get ingrained, is what stops central bankers from sleeping at night. Indeed, such a process lay behind the original meaning of the word 'inflation'; when a change of gear (up) takes place, people start expecting higher prices in future periods and adjust their behaviour accordingly, with for example workers demanding higher pay and firms setting higher prices. This feed-back process was an 'inflation'. Only in recent decades has inflation been taken to mean a rise in consumer prices.

During the Noughties, there has been a very long (six-year) run of positive surprises to oil prices – in the sense of actual prices rising year after year after year. What this hints at is that, first, expectations may be moving up through the gears again and, consequently, that most traditional macro-econometric models may now underestimate the impact of higher energy costs, at least if they are sustained.

Figure 1 illustrates the predicted effects of a one-off (but permanent) 20 per cent rise in the level of oil prices on the US economy, on both GDP and CPI – i.e. the sort of increase that happened in May.

These simulation results assume no policy reaction, an issue to which we turn next. Importantly, however, it is worth noting first that the natural tendency of even professional forecasters when faced with surprise increases in oil prices which might well turn out to be temporary – is not to put through the model-based effects fully into the forecast (just in case they need to be taken back again quickly).

What this means from a practical point of view is that, when there has been a long run of positive surprises – such as over the past year, when oil prices have risen about 20 per cent per quarter for four quarters in a row – there is a very good chance that the consensus has failed fully to take into account the deleterious effect on growth and inflation.

Figure 2 illustrates an upper bound of the possible size of the underestimate, showing what our models suggests the impact of four quarters in a row of 20 per cent per quarter increases in oil prices on US GDP and CPI.

Now the numbers look quite scary: had no-one changed their numbers at all, then they would likely be about 0.75pp too high in the case of 2009 GDP growth, and about 2pp too low in the case of headline inflation.

What can policymakers do about it?

For policymakers in countries that are not self-sufficient in oil – i.e. countries that consume more than they produce – very little can be done about the hit to activity and the rise in prices engendered by an increase in oil prices.

Provided that policymakers accept that they cannot do anything about the loss in real incomes (besides exhorting producers to increase supply), the best policy is to persuade households and firms that they must accept lower living standards, and do not try to find an offset.

In the Fed's case, the improved market sentiment since it acted to prevent the Bear Stearns collapse setting off a domino effect amongst the other investment banks (by permitting them to borrow directly from the Fed if they faced liquidity problems) meant that the Federal Open Market Committee was always likely to cool expectations of further rate cuts.

However, it has been less forthright in its language than the European Central Bank and Bank of England suggesting that 'sitting on its hands' is its preferred policy for now. Our attempts to gauge their likely success in adopting such a strategy augur well: for we suspect that growing slack will curb price pressures.

What lessons can be drawn from all this? We judge there are three main ones:

1. Higher oil prices will not stop US consumers spending their tax rebates – even though some of the money may well end up being used to fill up petrol tanks rather than used for other spending. Consequently, we retain the view that economic activity data will take a turn for the better over the course of the second and third quarters.

2. Inflation pressures will not recede for some time. Headline inflation is already high enough to cause headaches for many central bankers. Soon, that will turn to migraine level – with, for example, the BoE's governor having to write letters to the Chancellor of the Exchequer explaining why inflation was more than one percentage point above the official target.

That means that planned rate cuts will come through more slowly than seemed likely previously.

However, we suspect that markets have overreacted in thinking that the Fed might hike as soon as the early part of next year, or the BoE stay on hold the rest of this year, as is currently priced in.

3. Firms' profits will face a double whammy. More subdued demand growth (thanks to a higher cost of living for households) and higher costs of production both represent bad news for the corporate sector. Margins and earnings will end up weaker than would otherwise be the case.

Accordingly, we are minded to lower a little our projected path for firms' profits, and thus for equity markets. However, we feel that the impact should be fairly limited.



  - The author is Managing Director and Head of Research & Investment Strategy at Barclays Wealth and this column was taken from the Barclays Wealth June Signpost report.