Monday, 29 January 2007

Oil, the Fed, and the ECB

The International Herald Tribune today published an article discussing the fact that oil prices decreases are putting pressure on both the Federal Reserve and the ECB to hike rates still further – an interesting argument given the different perspectives of these central banks.

While oil prices were reaching highs of around USD 77 per barrel in 2006, the Fed was downplaying the increase in the headline inflation indices and focusing on the fact that higher oil prices acted as a tax on consumers, which would slow the economy and relieve pressure in measures of core inflation. On the other hand, the ECB was highlighting the risks posed by increases in headline inflation – particularly the risk that the higher headline numbers might result in an increase in the inflation expectations held by labor unions and business leaders during wage bargaining rounds.

Now that oil prices are decreasing, the Fed is expressing concern about the oil’s impact on the economy and the risk that core inflation readings will move higher – consistent with their model of the economy and their general focus on core rather than headline inflation measures.

The ECB appears to be less consistent in its treatment of oil price moves these days. ECB members are highlighting upside risks to core readings for a change – ignoring the downward pressure on headlines measures – and also pointing to possible second-round effects of past oil prices rises.

Is the ECB being intellectually inconsistent – perhaps because of its desire to move rates higher regardless of the economic environment?

In my view, the key driver for the ECB for some time now has been their concern over M3 growth within the eurozone. M3 was growing too quickly for the ECB as oil prices were increasing – and recent data show it growing even more rapidly now. The ECB is one of the most monetarist of central banks, and the market has repeatedly underestimated the concern that ECB members have with rapid money and credit growth.

I attended a dinner with Trichet in New York a few months ago, and I was impressed by his focus on money and credit growth – particularly private credit. More important, he noted that he was surprised that the market hadn’t really appreciated the ECB’s focus on this issue.

A decrease in the price of oil should help to further stimulate the growth in credit components within the eurozone – adding to the ECB’s concerns about inflation over the medium-term. For this reason – more than concerns they have about GDP growth per se or second round effects of previous oil price increases – the ECB is expressing concerns about recent oil price declines.

The transmission mechanism by which the ECB sees oil prices as having an impact on medium-term inflation is money and credit growth, and I continue to believe that the key to forecasting ECB policy this year is forecasting the growth of money and credit balances within the euro area – and anticipating the ECB responses to those increases.

Saudis using oil to constrain Tehran?

The front page of today’s WSJ Europe had an interesting article entitled, “Can Russia, Iran endure oil pinch” highlighting the difficulties that the governments in Russia, Iran, and Venezuala are facing with oil down from a high of around USD 77 in August. More interesting, today’s International Herald Tribune contains an article entitled, “Saudi Arabia’s cryptic signals,” (from yesterday's NY Times) with a key passage:

Oil traders have been buzzing in recent weeks about whether Saudi Arabia was actively seeking to depress oil markets in the hope of crippling the Iranian economy, as a Saudi analyst — albeit not one from the government — suggested in an opinion article in The Washington Post last year. The Saudis quickly dismissed the suggestion, but given the tensions in the Middle East, oil and politics remain closely linked.

Though not reported in the NY Times article, the analyst in question, Nawaf Obaid, was the director of the Saudi National Security Assessment Project in Riyadh, an adjunct fellow at the Center for Strategic and International Studies in Washington, and a consultant to the Saudi Embassy in Washington. After publishing the article in question, Prince Turki, the Saudi ambassador, terminated the embassy contract with Obaid, ostensibly to distance himself from the policy outlined in the article.

The buzz is that the former Saudi Ambassador and long-time friend of the Bush family, Prince Bandar, is advocating the policy outlined by Obaid in the Washington Post article: namely that the Saudis will fund the Iraqi sunnis in the event of a premature US withdrawal from Iraq -- and also that the Saudis will increase the supply of oil on the market in order to push the price low enough to hurt the Iranians and to limit their ability to fund the Shiite insurgency in Iraq and Hezbollah in Lebanon. It's understood that Prince Turki advocates another policy – one involving a regional dialogue to include the Iranians -- and that his resignation was in protest to Bandar’s continuing contacts with the US Administration. (Bandar and Turki are both said to be maneuvering to replace Turki’s ailing brother, Prince Saud al-Faisal, as Saudi Foreign Minister.)

Besides Saudi efforts to pressure Iran, there are of course numerous other reasons offered for the decrease in the oil price since August of last year, including:

  • A milder-than-expected hurricane season in the Atlantic;
  • Milder-than-expected December temperatures in the northeastern US and in Europe; and
  • Oil exporter concerns over the investment in alternative energy.

Also mentioned have been global slowdowns in the US and in China, but recent data suggest growth has actually been more robust than had been expected in both economies.

My longer-term expectation had been that oil prices would decline from their highs, as oil producing nations try to head off the large investment that could help develop alternative energy sectors. My understanding was that this hadn’t taken place yet because years of underinvestment had left the Saudis and others with little ability to dramatically increase production. In that light, my near-term expectation was that oil prices would increase as global growth continues apace.

But recent articles about the Saudis moving to increase production so as to lower the oil price and cripple Iran have given me cause to reconsider. If the Saudis have been able to increase production – and have an ability to increase production still further – their interest in restraining Tehran and in slowing the growth of alternative energy sources are two good reasons for them to attempt to engineer still further price declines.

So – a few key questions to research:

  • Have the Saudis increased production by a meaningful amount in recent months?
  • Do they have the ability to increase production significantly going forward?
  • Which Saudi faction will win the debate about Middle East policy, particularly as it pertains to the use of oil prices as a lever vis-à-vis Iran?

The answers to these questions may be as important to discerning trends in oil prices these days as any analysis of the demand side.