MONETARY POLICY

The ECB's Oil Price Trap

European Central Bank President Mario Draghi Speaks in Berlin
Mario Draghi faces a tricky decision if oil prices continue to rise.
  • Why it matters

    Why it matters

    If the price of oil were to increase to $80, euro-zone inflation would likely rise above the 2 percent “price stability” threshold. That could hurt growth.

  • Facts

    Facts

    • OPEC oil-producing states agreed last month to cut production, which means significantly higher oil prices are probable.
    • The treaty on the functioning of the European Union charges the ECB with ensuring price stability.
    • There is a risk of deflation when inflation remains appreciably below 2 percent.
  • Audio

    Audio

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Economic policy is normally used for a prescribed goal, such as reducing long-term unemployment.

The political debate then revolves around what are the best instruments to achieve that objective. For cutting joblessness, for instance, shorter working times for everyone, a lower minimum wage or measures to increase qualifications might be suitable.

If, on the other hand, you look at economic policy of the European Central Bank, the path itself appears to be the goal — namely, negative interest rates and massive bond buying.

The ECB economists are well aware that consumer price inflation is influenced to a large degree by oil prices. Even if low oil prices persist, inflation will likely increase in the euro zone from the current 0.4 percent rate to about 1.2 percent early next year.

Deflation is only dangerous when prices fall due to pronounced restraint in consumer spending.

Thats’s because the effects of collapsing oil prices on the year-on-year inflation rate are coming to an end. OPEC oil-producing states agreed last month to cut production, which means significantly higher oil prices are probable.

ECB president Mario Draghi would then have two uncomfortable alternatives — either change its monetary policy or redefine price stability.

The treaty on the functioning of the European Union charges the ECB with ensuring price stability. But it doesn’t say what price stability is.

The ECB’s Governing Council defined price stability when it assumed office in 1998: “Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2 percent.”

This meant an inflation rate of 0.5 percent would conform to the mandate, as would one of 1.8 percent.

In May 2003, the ECB Governing Council changed this target to “below but close to 2 percent”— meaning that the definition of price stability could no longer be achieved with an inflation rate of 0.5 percent.

A key justification for this change was the risk of deflation when inflation remains appreciably below 2 percent.

Deflation is, in fact, an ugly economic problem. But it is wrong to interpret every fall below a self-set inflationary goal as a sign of deflation.

Deflation is only dangerous when prices fall due to pronounced restraint in consumer spending. Only then is there the threat of a downward spiral. So far, this has only been observed once, during the Great Depression of the 1930s. Since that time, deflation has been more of an academic phenomenon than a real economic problem.

The ECB never tires of asserting that its policy is aimed at maintaining price stability — at the level it set itself.

Thus Mr. Draghi recently stressed on TV, “We need more growth. More growth will reduce the unemployment rate in all of Europe. And when that takes place, we will then also have higher nominal wages and, in the end, also an inflation rate in the range we are striving for.”

September was an early indication that what happens in coming months will have nothing to do with monetary policy.

Inflation in the euro zone went up from 0.2 percent to 0.4 percent, because the price of oil was around 5 percent higher than in the previous month. And since the price of oil had plummeted down to $30 at the end of 2015, even given this constancy, consumer prices will noticeably increase in coming months.

If the price of crude should increase to $80 as a result of OPEC’s decision to increase production, the inflation rate would rise above the 2 percent “price stability” threshold.

That would burden large sections of the economy. Profits and consumer buying would be subdued, and growth in the euro zone would be curbed.

Mr. Draghi could define this rise as a short-term effect and ignore it. But then he would have to explain why he didn’t do that with the preceding drop in oil prices.

Alternatively, the ECB could switch to the core inflation rate in measuring inflation, meaning the rate of price increase without widely fluctuating food and energy prices, which are uninfluenced by the monetary policy. This is currently 0.7 percent in the euro zone.

In that way, continuing the ultra-loose money policy could be justified. But the reasons for entering into this policy two years ago would lose their validity.

By doing so, the ECB would indirectly admit that its warnings of deflation were in truth serving another purpose. That would confirm its critics fears — not to mention massive collateral damage in many other areas.

Either way, Mr. Draghi’s critics would be given new ammunition. In the end, he can only hope that OPEC’s attempts to raise oil prices fail. But that won’t make a continuation of ultra-loose monetary policy any more correct.

 

To contact the author: ruerup@handelsblatt.com

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