Sunday, February 27, 2011

Naked Capitalism: Oil, Central Banks and Interest Rates


On the Problem Rising Oil Prices Pose for Central Banks

SUNDAY, FEBRUARY 27, 2011


Ambrose Evans-Pritchard of the Telegraph voices his concern that central banks are going to misread the impact of rising oil prices and therefore make the wrong interest rate decision. Bear in mind that Evans-Pritchard called the 2008 oil spike correctly, deeming it to be a bubble, and was also in the minority then in arguing that deflation was a bigger risk to the economy than inflation.
One leg of his argument is that oil price increases slow economic growth. That’s hardly startling; indeed, this concern has been echoed widely in the last few days. For instance, as David Rosenberg notes, courtesy Pragmatic Capitalism:
It is also interesting to see how government bond markets are reacting to the oil price surge — by rallying, not selling off. In other words, bond market investors are treating this latest series of events overseas as a deflationary shock.
Evans-Pritchard highlights several issues: no one seems to have a good measure of the impact, but there is reason to think it is larger than most central bankers allow for. And it also appears to be subject to inflection point effects, where increases beyond certain thresholds have disproportionate effects:
The classic theory by Rotemberg and Woodford (1996) is that a 1pc rise in crude prices cuts 0.25pc off US output over six quarters or so. If they are anywhere near correct – and the “energy intensity” of the US economy has diminished over time – the sort of 40pc rise since last summer rise will indeed have a severe effect. Subsequent scholarship suggests this is too extreme, unless central banks behave like idiots.
Deutsche Bank says US crude at $120 a barrel would push oil costs to 5.5pc of global GDP, the trigger level that has historically caused upsets….
Eduardo Lopez, a veteran oil watcher at the International Energy Agency, said the world was already “approaching dangerous waters” before North Africa blew up. He places the inflexion point at around $90 for US crude.
READ FULL POST HERE 

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