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Global central banks react differently to higher oil prices

Economic Research and Analysis: Economics Weekly
www.lloydstsbfinancialmarkets.com

Global central banks react differently to higher oil prices


Overview
Central banks responses to higher oil prices have been noticeable by their difference. We look at possible reasons for this in this week’s briefing. This is especially pertinent in the UK since financial market momentum seems to be building for a further cut in short term interest rates by the Monetary Policy Committee (MPC).

Different reactions to high oil prices
It is striking that the response by three major central banks to the impact of higher oil prices has elicited three different outcomes, see chart A. In the US, the central bank, the Fed, has continued to raise interest rates, warning about the risks to price and wage inflation, in spite of the devastating impact of the worst storms in many decades. In the Euro area, where the ECB is responsible for monetary policy in twelve countries, interest rates have been kept on hold, but there is increasingly strong rhetoric from officials warning about the potential effects of higher inflation. In the UK, interest rates have been cut, by 0.25%, taking them to 4.5%. What accounts for this different interpretation of inflation risks from higher oil prices? We examine whether the reason lies in differences in economic growth, consumer price inflation, or wage inflation.

Economic growth differs,/b>
Chart B looks at economic growth for the three monetary areas. US economic growth is seemingly unaffected by the rise in oil prices or the effects of hurricanes Katrina and Rita, or at least not yet. By contrast, economic growth in the UK has been falling sharply since 2004, though on a quarterly basis it may have stopped declining after a rise of 0.5% in Q2 this year from just 0.3% in Q1. Euro area economic growth has also fallen since 2004. Although this fall has not been as sharp as in the UK, it has been to a lower level. This may seem to suggest that the ECB could justify a cut in interest rates but has instead chosen to leave them on hold. Continued fast economic growth would seem to justify the US Fed continuing to raise interest rates while the slowing UK growth trend justifies a cut in rates.

Consumer price inflation is accelerating…
Consumer price inflation trends would seem to
confirm the fears of the US Fed. US consumer price inflation is certainly higher than in the UK or euro area and is accelerating, see chart C. For the UK, inflation is well below that of the US, but is rising equally quickly and is above the 2% target. But despite this the fall in UK growth suggests interest rates being kept on hold, rather than raised. (This was of course the outcome at the October MPC meeting). For the euro area, consumer prices are rising at about the same pace as in the UK, but have been flat for the last few years and are rising only gently. This would suggest euro official interest rates staying on hold for the time being.

…but pay inflation is still stable
Monetary policy makers worry about future price inflation and about the so called ‘secondary effects’ of higher oil prices, as the impact on consumer price inflation feeds through to wage inflation. Looking at wage inflation trends in the US, UK and euro zone however, see chart D, does not suggest that wage inflation is about to take off in any of them. However, the chart does illustrate that wage inflation is rising fastest in the UK, though accelerating from a low level quickest in the US. Pay inflation in the euro area, illustrated by Germany in the chart, is the lowest of the three economies and is registering a flat trend. This pattern of pay rates would support flat interest rates in the US and euro area, but vigilance for the former and perhaps pre-emption. For the UK, it suggests that vigilance on wage inflation is also required, as it is already at a high rate and could reach much higher levels should it accelerate from its current position. If the trends of growth and price inflation are considered together, then the US monetary authorities seem justified in raising interest rates further and warning about the risk of feed through to what is still low but rising wage inflation. In the UK, cutting interest rates would seem risky at present as though economic growth has weakened, price inflation is rising quickly and wage inflation is high, albeit stable. For the euro area, a cut in interest rates could still justified, just, given the low rate of growth. Although the rhetoric from ECB officials about inflation risks has increased in recent weeks, there are few signs of an actual meaningful acceleration in wage increases, though off its lows, so a rise is not yet justified, see chart D.

The price of getting it wrong would be high,/b>
Central banks have taken great effort in the last two
decades to get inflation expectation amongst companies and households down to low levels by taking strong action to keep actual inflation low and stable. The risk of getting that wrong by allowing inflation to seep back into the system is what makes them quick to react to inflation threats. The price of getting it wrong would be higher interest rates in the future and hence lower output. In the euro area, the ECB is worried about inflation, given the history of it in Europe. The US is still very concerned about inflation risks, given how low interest rates have been and a booming housing market. However, the UK monetary authorities seem more worried about growth than inflation compared to the ECB. But even in the UK a further interest rate cut would seem dependent on even weaker growth than seen so far, since inflation does seem set to accelerate further.

UK economic indicators
The focus this week will be on producer price inflation, Monday. We look for a modest acceleration. But oil prices eased back in September, so the annual rate should fall back. Unemployment, Wednesday, will also be watched for what it might mean for consumer confidence and the trend of economic growth. We look for little change in the data, with annual wage inflation stable at around 4% and employment still rising. The trade deficit, on Tuesday, will give a guide to how the international economy is impacting the UK. We look for another stable trade deficit, of around -£5bn for global trade in August.
Trevor Williams, Chief Economist

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