How Oil Complicates Monetary Policy
Is the recent dramatic drop in oil prices ultimately good news or bad news for the U.S. and Europe? And how should it affect monetary policy?
There's a simple opening answer to both questions -- and then some complications that, under present circumstances, demand attention.
To start with, a lot depends on why the price of oil has dropped. The main reason in 2014 has been an increase in global supplies due to advances in the technology of oil extraction -- the tight-oil revolution. Increased supplies of oil lower the price. This cuts costs in oil-importing countries, expands their productive capacity, and raises their output and real incomes.
Even though the U.S. has lately been the world's biggest oil producer, surpassing even Saudi Arabia, it still consumes more oil than it produces and remains a net importer. Europe is heavily dependent on oil imports. So cheaper oil makes Americans a bit better off, and Europeans a lot better off. It's bad news for Russians, but good news for the U.S. and the European Union.
Confusion next arises because cheap oil not only increases real output but also reduces inflation. Does this call for a loosening of monetary policy, to push inflation back up to target?
Ordinarily, central banks would expect the fall in inflation to be temporary, and they'd typically let it happen, allowing inflation to come back up later without further intervention.
Remember, we're assuming that the price of oil has fallen mainly because of technology, not because of a slump in the global demand for oil. So it's not as though the oil-induced fall in inflation is associated with an upward blip in unemployment or the appearance of spare capacity in the economy. Indeed, output will be higher than it would have been otherwise. All this being the case, central banks would usually be inclined to "look through" the temporary drop in inflation, as they'd say, and see no need to loosen policy.
Now for the complications. There are plenty, but three deserve to be stressed.
First, technology may be the main reason oil prices are lower, but it isn't the only one. Commodity prices in general have fallen over the past year, though not nearly as much as the price of oil. So there's more to this story than fracking. James Hamilton of the University of California, San Diego, watches energy markets closely and reckons that two-fifths or more of the decline in oil prices could be due to "new indications of weakness in the global economy." Those new indications, other things equal, point to persistent spare capacity and excess unemployment, and do call for a further loosening of monetary policy. On this view, to be clear, cheap oil in its own right doesn't call for additional monetary stimulus; it's the worsening demand conditions that first gave rise to cheap oil.
Second, the effects of cheap oil vary from country to country and industrial sector to industrial sector. These differences can have implications for monetary policy. For instance, cheap oil tends to weaken the currencies of oil exporters such as Russia -- in the ruble's case, it's a rout. By the same token, this puts upward pressure on the dollar and euro. An appreciating currency constitutes a tightening of monetary conditions. Again, that might be a reason to apply new monetary stimulus.
Third, and most important, there's the danger that the temporary fall in inflation due to cheaper oil will lower long-term inflation expectations. If that happens, the temporary fall in inflation won't be temporary after all. Financial markets might be wrong to deduce that cheap oil will suppress inflation in the longer term. If they do draw that conclusion, however, it won't matter that their reasoning is faulty. The ensuing new forecast will tend to be self-fulfilling. In the end, they'll be right for the wrong reasons.
This last possibility is far more of a concern for the European Central Bank than it is for the Federal Reserve, because the euro area stands on the brink of a third recession and outright deflation. In yesterday's statement and press conference, Fed Chairman Janet Yellen had little to say about the oil-price drop -- a forgivable omission. But Europe has more at stake. A further downward push to EU inflation, which might be temporary under normal circumstances, could tip the balance in 2015, and put the euro area on a persistent deflation path.
Overall, then, I'd say the fall in oil prices tilts the balance in the U.S. gently in favor of extended monetary stimulus -- meaning, the Fed should delay the move back to normal, higher interest rates a little longer. (Signs of a tightening labor market, when there are some, would override that calculation.) In the EU, it argues much more powerfully for aggressive monetary stimulus in the form of outright quantitative easing. That case has been strong, of course, for many months anyway. The price of oil just makes it stronger.
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