Shock tactics: Oil prices have risen sharply in recent months. Yet the US Federal Reserve appears to be far less concerned about the inflationary impact than its European counterpart
Financial Times, Saturday, August 26
By Ed Crooks
In the past 18 months, oil prices have roughly tripled. Brent crude - the benchmark measure - has risen from a little over Dollars 10 a barrel in February 1999 to more than Dollars 30 yesterday. This week provided the clearest indication yet that this dramatic ascent - comparable in scale to the price rises of 1973 and 1979 - may be beginning to hurt Europe's economy.
A gloomy Ifo business survey released on Tuesday seemed to indicate that Germany, Europe's biggest economy, is set to slow down before its recovery has really got off the ground. Despite signs of a slowdown, and despite an unemployment rate in the euro-zone of more than 9 per cent, the European Central Bank still looks likely to raise interest rates next week because inflation has been pushed above target by higher oil prices.
"It is really becoming serious," says Eric Chaney of Morgan Stanley Dean Witter. "We are in a situation maybe not so different from the oil shocks of the 1970s." Oil-consuming nations have bitter experience of what that could mean. Prices rise and real incomes fall as resources are lost to oil producers. If unions and companies try to restore real wages and profits by pushing up pay and prices, inflation can start to spiral upwards.
The developed economies have become more energy-efficient over the past two decades, improving energy consumption per unit of output by about 25 per cent since 1980. Some analysts also argue that the shift of modern economies away from manufacturing and towards communications and internet-based services has made oil prices less pivotal. But, despite the changes in the structure of the US economy since 1989, oil consumption has still risen by 11 per cent.
"Energy is still a key input: the new economy runs on gasoline and aviation fuel," says Andrew Oswald of Warwick university. He points to the recent signs of a slowdown on both sides of the Atlantic as the first evidence that higher oil prices are beginning to bite. In previous oil shocks, it took about 18 months for the effects of oil price rises to start having their full effect.
Yet the evidence of a new oil shock remains mixed. While Germany is clearly feeling the effects, the US economy appears to have been hit less hard. At first glance, this seems odd. The US is home to the gas-guzzler car and the walk-in refrigerator, and the consumption of oil is often regarded as close to an inalienable right. In contrast, Germany has a fascination with using fuel economically, and its government includes Green party politicians.
The US economy is indeed much more energy-hungry than Europe: it needs the equivalent of 330 tonnes of oil to generate Dollars 1m of gross domestic product, compared with 190 tonnes in France and Germany and 140 tonnes in Europe. Furthermore, taxes on fuel in the US are minimal relative to those in most European countries. Rising crude oil prices translate more directly into higher consumer prices.
But while both the US and the euro-zone economies are expected to slow down later this year, the US is apparently slowing to a rate that will still be faster than Germany's growth at its peak. Why is Europe suffering more?
In part, it is because the US is an oil producer as well a consumer. Western Europe's only oil producers of any size are Britain and Norway, neither of them in the euro-zone. Although it is the world's largest oil importer, the US manages to produce 40 per cent of its oil consumption. Net oil imports account for 0.7 per cent of GDP in the US, but 1.1 per cent in the euro-zone. So the net loss of wealth and output will be greater in Europe.
But a more important difference is the way policymakers have responded to the oil price rise. There is no right or wrong answer for how a central bank that is trying to control inflation should respond to an oil shock. It depends on what else is going on in the economy, and whether other prices - and above all wages - rise in response.
Charles Wyplosz of the Centre for Economic Policy Research argues that the quicker the central bank moves to damp down inflationary expectations, the less painful the ultimate result. "Clearly the lesson of the 1970s and 1980s is that it is good to act fast, by not allowing inflation to rise and expectations of higher inflation to become established. That is what the Germans did in the 1970s, and what the French, Italians and British did not do."
But some economists argue that the ECB is over-reacting. Gustav-Adolf Horn of the Deutsches Institut fur Wirtschaftsforschung, a Berlin-based economic research institute, points out that domestically generated inflation in the euro area is still very low. Headline euro-zone inflation is above the ECB's target rate of 2 per cent. But while it has risen to 2.4 per cent, inflation excluding energy is just 1.4 per cent. Wage settlements in the euro-zone seem to be running at about just 2.5 per cent.
Mr Horn says changes in the European economies mean they are less vulnerable to oil price rises causing wage-price spirals. "If you look back at the oil shocks of the 1970s, the wage reaction was very different. Wages rose very quickly in an attempt to compensate workers for the rising oil price. But today the structure of the labour market has changed, and trade unions know it would be in vain to bid up wages."
Members of the ECB's council are less sanguine, believing that if they wait for pay growth to pick up, it may already be too late. Otmar Issing, the hawkish chief economist, has several times warned in recent days that the outlook for inflation has "deteriorated", largely as a result of the rising price of oil. It seems all but certain that the ECB will raise rates again, if not at the council meeting next Thursday, then at the subsequent one on September 14.
This is in sharp contrast to the attitude of the US Federal Reserve. Headline consumer price inflation has risen to an annual rate of 3.5 per cent, but the Fed decided to leave interest rates unchanged this week, and looks set to leave them unchanged for the rest of the year. "The Fed's position is that if we do not see an effect on core inflation, it probably does not need to get too worried about oil," says Jan Hatzius of Goldman Sachs in New York.
Core inflation excluding food and energy is steady at 2.4 per cent, and as in Europe, there is still no sign of higher oil prices pushing up pay. Hourly wage rates are rising at a bit less than 4 per cent a year, which is what they have been doing for the past four years. The drain on consumer spending caused by higher oil prices - estimated by Merrill Lynch at Dollars 50bn this year - will also help to slow the economy.
The ECB might plausibly adopt the same approach, but it is held back by the problem a central bank dreads above all others - lack of credibility. With only 20 months of history behind it, and without the enormous personal authority of Alan Greenspan, the ECB cannot take a relaxed attitude to headline inflation and be confident it will be trusted to bring inflation back on track. Already expectations of future inflation in the euro-zone have risen to their highest level for four years.
"The ECB has tied its own hands with its 2 per cent inflation target. Since it still has to establish credibility, headline inflation rising above 2 per cent, and remaining above it for a relatively long period of time, is a big problem," says Mr Chaney. Nor are matters likely to become much easier for the ECB. Oil prices have already defied the hopes of forecasters who predicted they would fall back steadily this year.
With stocks low and and winter on the way, some analysts predict a new all-time record of Dollars 50 a barrel for Brent crude. That would put severe pressure on the global economy. Even if prices merely stick near the Dollars 30 mark, pessimists expect that both inflation and unemployment will rise in the US and Europe. With the ECB still in its infancy, and anxious to prove itself, the coming year could be distinctly uncomfortable in the euro-zone. |
