Dr. P.V. Viswanath

pviswanath@pace.edu

The crude art of policymaking: How should central banks respond to a rise in oil prices?

Jun 10th 2004
From The Economist print edition

INFLATION is creeping up. The euro area's average rate of consumer-price inflation rose to 2.5% in the year to May, up from 1.6% in February and well above the 2% ceiling set by the European Central Bank (ECB). America's 12-month inflation rate for the same month (due to be published on June 15th) is expected to rise towards 3%, up from 1.7% two months earlier. The blame for this jump in inflation lies largely with higher oil prices. Despite a dip over the past week, crude oil prices are still 25% higher than a year ago. Should central banks raise interest rates in response to a rise in the oil price?

As Alan Greenspan, the chairman of America's Federal Reserve, acknowledged this week, the answer is not clear-cut. The dilemma is that higher oil prices not only push up inflation (thereby calling for a rise in interest rates), but also dampen growth (requiring rates to be lower than otherwise).

The best way to understand this is to use a standard economic diagram of aggregate demand and supply. In the left-hand chart, the economy is in equilibrium at the point where the aggregate demand curve D1 and the aggregate supply curve S1 intersect, at price level P1 and output Q1. A higher oil price hurts an oil-importing economy in two ways. First, it increases firms' production costs and reduces profits, so they supply fewer goods and services at any given price. This shifts the aggregate supply curve to the left, to S2. Second, higher oil prices transfer income from oil-importing countries to oil producers (some of this may come back as higher exports). Since income and spending are squeezed in the oil-importing countries, the aggregate demand curve also moves left, to D2.

The economy therefore suffers both a negative supply shock and a negative demand shock. Output clearly falls (to Q2), but the impact on underlying inflation is ambiguous: in theory it could rise or fall, depending on the shapes of the demand and supply curves and the relative sizes of their leftward shifts. Some economists even argue that a rise in oil prices is “deflationary”, justifying a cut in interest rates. But this is a misuse of the term. Higher oil prices will deflate demand, but they are unlikely to lead to lower prices. Prices are much more likely to rise, to somewhere like P2 in the chart. Higher oil prices always push up headline inflation. The key issue is whether dearer energy will also feed into prices and wages across the whole of the economy.

In fact, higher oil prices are neither inflationary nor deflationary in themselves. It all depends upon how monetary policy reacts—and hence on where the demand curve ends up. The right-hand chart shows how policy responded after the 1973-74 oil-price shock. In an attempt to prevent output falling, governments embarked on substantial fiscal and monetary easing. For example, America's Federal funds rate was cut from 11% in mid-1974 to less than 6% in 1975, resulting in sharply negative real interest rates. In effect, this stimulus pushed the demand curve out to the right, to D3, with the aim of supporting output at Q1. But as a result, prices soared to P3. To bring inflation back down, central banks later had to slam on the brakes, which then caused a deeper recession.

Having learnt this lesson, central banks raised interest rates after the oil-price shocks in 1979-80 and 1990-91, to try to hold inflation down. Going back to the left-hand chart, that would imply a further leftward shift in the demand curve and hence a larger loss of output. However, it is important to note that a rise in interest rates does not necessarily imply a tightening of policy if inflation has been pushed up by higher oil prices. Central banks then need to raise interest rates simply to keep real interest rates steady.

Shocked to the core
One clear lesson from the past is that while a central bank cannot prevent oil prices giving a one-off boost to inflation, it must try to prevent this feeding into higher wages and prices of other goods and services. If there is no sign of a rise in the core rate of inflation (excluding energy prices), then there is no need to raise interest rates. There is evidence that rises in headline inflation tend to spill over into wages faster in Europe than in America, because of its less flexible labour markets. If so the ECB is right to be more vigilant when oil prices rise.

On the other hand, the cyclical position of the economy also determines whether central banks need to raise interest rates. The less slack there is in an economy, the bigger the risk that higher oil prices will feed quickly into wages and that firms will be able to pass on higher costs. The recent strong pace of growth in America and the rise in its core inflation rate therefore make a strong case for a rise in interest rates now. In contrast, when oil prices shot up early last year, when the economy was weak and there were clear risks of deflation, the correct response was to cut rates. Today, the euro area still has much more spare capacity than America and so the risk of a jump in wage demands should be smaller. But the ECB is rightly keeping a keen eye on inflationary expectations. Bond markets are signalling a worrying rise in inflation expectations in the euro area as well as in America.

There is also one important difference between the latest oil price rise and those that have been experienced in the past. Previous jumps in the oil price were typically caused by a sudden disruption to supply. In contrast, the recent price increase is largely due to strong demand for oil because of a booming global economy, especially in America and China. Global output is rising at its fastest pace in 20 years. Last year, China accounted for no less than one-third of the increase in world oil consumption. From this point of view the rise in oil prices is an inevitable, even desirable, consequence of a booming world economy. China may be pushing oil prices up, but it is also importing lots of other goods from the rest of the world: it has shifted out the demand curve in developed economies. With fewer negative implications for growth, the inflationary threat from higher oil prices is greater. This further strengthens the case for the Fed to lift interest rates soon.