Newspaper article International New York Times

Central Banks Face Puzzle in Oil Prices

Newspaper article International New York Times

Central Banks Face Puzzle in Oil Prices

Article excerpt

Oil prices go up and down -- there's nothing you can do about it - - but when they do, it doesn't tell you much about the longer-term path of inflation.

When is good economic news a reason to worry?

When you're a central banker fighting a slump toward deflation, or broadly falling prices, at a time when oil prices are plummeting. And this is the situation that Mario Draghi, the president of the European Central Bank, faced as he announced the results of the bank's latest policy meeting on Thursday. How he wrestles with that problem will determine the outlook for Europe's flailing economy.

The official line from many of the world's most influential makers of economic policy is that the drop in oil prices is fantastic news for global growth, at least in places that don't count oil production as their dominant local industry.

"If I was to address an audience in Saudi Arabia, Qatar or Kuwait, I wouldn't discuss it exactly the same way," Christine Lagarde, the managing director of the International Monetary Fund, said at an event in Washington this week. "But on a net-net basis, it is good news for the global economy."

The fund estimates that a 30 percent decline in oil prices should improve growth by 0.8 of a percentage point in most advanced economies, Ms. Lagarde said. And prices are down more than that -- about 35 percent since June 30.

There is little doubt that falling prices for oil and other commodities are good news for global consumers. Less money spent on gasoline and other fuels means more to spend on everything else, in effect raising people's real incomes.

But the challenge Mr. Draghi and his fellow central bankers face is that they are trying -- almost desperately -- to attain higher inflation, closer to the 2 percent they target. And falling oil prices will drive inflation down further, particularly as the lower price of oil ripples through global supply chains and starts to affect more retail prices.

In Central Banking 101, they teach you this about fluctuations in energy prices: It would be unwise to react to short-term moves that will have only a transitory effect on inflation. Oil prices go up and down -- there's nothing you can do about it -- but when they do, it doesn't tell you much about the longer-term path of inflation. Central bankers should keep looking over the horizon and focusing on the medium term.

Following that guidance, central bankers would do pretty much whatever they were planning to do a few months ago, before the oil sell-off began. For the Federal Reserve, that would mean raising interest rates in mid-2015

But the Central Banking 101 lesson changes when a move in the price of oil and other commodities has some lasting effects on people's psychology. In the 1970s, for example, the oil price spikes caused by the Arab embargo combined with steadily increasing prices and wages to make people expect ever-increasing inflation, which became self-fulfilling as the decade progressed. …

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