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.

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