Will Central Banks Accommodate the Oil Price Shock?

Inflation rates are rising in the world's major economies. The consumer price index rose by half a percent in the United States in February, equivalent to an annual rate of 6.2 percent. Consumer prices rose at a 4.4 percent annual rate in the UK and a 2.4 percent rate in the euro area. All three central banks have explicit or implicit inflation targets of 2 percent or less.

In all three economies, rising oil prices accounted for a big part of the increase of inflation. That fact poses a dilemma for monetary policy. Should central banks tighten monetary policy to counteract the effects of oil price increases and prevent general inflation? Or should they instead accommodate oil price increases with easy monetary policy, in order to maintain growth of output and employment? Two problems make the choice a difficult one.

The first problem is that nothing central bankers can do will prevent an increase in world oil prices from harming an oil-importing economy. It must either be left with fewer other goods and services after paying for the oil it imports, or learn to live with less oil, or go deeper in debt, or do a little of each. Monetary policy, at best, can only determine what form the damage takes.

The second problem is that central banks have little direct control over the real economy, as manifested in variables like real GDP and employment. By and large, monetary policy can only control the growth of nominal GDP. If it applies its policy instruments correctly, a central bank could, for example, cause nominal GDP to grow at four percent per year rather than 0 percent per year. However, it cannot do much to determine whether that four percent nominal growth will consist of 4 percent greater output of real goods and services, without inflation; 4 percent inflation without growth of real output; or some combination of inflation and real output change that adds up to four percent.

Putting these two problems together leaves the central bank of an importing country with limited options when an oil price shock hits:

1. It can tighten policy to keep inflation from rising. Doing so will cause real GDP to decrease, or at least to lag behind the growth of potential real GDP. The resulting negative output gap will cause the unemployment rate to increase.
2. It can use expansionary monetary policy to try to offset the impact of oil prices on real output and employment. However, doing so will cause nominal GDP to grow faster. Given the negative impact of the oil shock on real GDP, inflation will accelerate.
3. It can compromise by doing nothing, that is, hold the rate of growth of nominal GDP to its previous path, despite the oil price shock. The result will be intermediate between Cases 1 and 2, that is, there will be some increase both in inflation and unemployment.

None of these options is completely satisfactory. None of them fully neutralizes the harm done by the oil price increase. The choice among them depends on the phase of the business cycle at the time oil prices spike, the preferences of the monetary authorities,the legal framework they work in, and the need to coordinate monetary policy with fiscal policy. Those factors play out somewhat differently for the central banks of the United States, the UK, and the EU, so we should expect different policy decisions.

The situation in the UK is shaped by the aggressive program of austerity being followed by the Conservative-Liberal Democrat coalition government that was elected last year. The program proposes reducing government spending by nearly a fifth and cutting half a million government jobs. Austerity is not limited to cuts in discretionary spending. There are cuts to entitlements, including a scheduled increase in the retirement age, cuts to a health-care system that is already relatively austere by European standards, decreases in defense spending, and tax increases.

A case can be made for the UK's austerity program, considering that the budget deficit in 2010 was among the largest of all developed economies. However, it came at a time when the British economy was just beginning to recover from recession. In the fourth quarter of 2010, real GDP actually decreased. That left monetary policy with the burden of preventing a full-blown double-dip recession. The Bank of England, which had already lowered its main policy interest rate to 0.5 percent, undertook further expansionary policy with a program of quantitative easing. The combination of low interest rates and QE was expected to restore real GDP growth in 2011, but only at 1.7 percent, not enough to keep up with the growth of potential GDP.

Given the circumstances, the Bank of England, so far, has opted for accommodation. Despite January and February inflation more than twice the bank's target rate of 2 percent, six of the nine members of its rate setting committee voted to keep rates low at their most recent meeting. To try aggressively to bring down inflation at this point would not only undermine already-weak economic growth, but would also risk failure for the fiscal austerity plan itself, which depends for its success on a growing tax base and a falling unemployment rate.

In the euro area, circumstances would also appear to favor accommodating the oil shock, or at least taking a neutral stance. Real output growth in the euro area, as in the UK, is expected to be weak this year, just 1.6 percent. Inflation in February was less than half a percent above the 2% target rate, a smaller overshoot than in the United States or the UK. The ECB's policy interest rate, unlike those in the UK and the United States, was never cut below 1 percent. Several euro area economies, notably Greece, Ireland, and Portugal, are in the midst of stringent fiscal austerity programs, which could be derailed by a tightening of monetary policy.

Nonetheless, it appears that the ECB will soon raise interest rates. One reason is the uneven pace of euro area growth. Although peripheral members of the euro are struggling, growth in the core economies of Germany and France is strong. More importantly, the ECB is more inflation averse than the Fed or the Bank of England. The treaty that brought the ECB into existence gives the central bank a strong mandate to focus single-mindedly on inflation. Willingness to take that mandate seriously has been a litmus test for appointments to its executive board.

As one token of its hard-line approach to inflation-fighting, the ECB focuses exclusively on headline inflation, which includes all goods and services. Other central banks pay more attention to core inflation, which excludes volatile food and energy prices, and is currently running well below headline inflation. As a result, the ECB's official inflation target of 2 percent, although nominally on a par with those of the United States and the UK, is effectively more stringent.

Also, the ECB appears to give more weight to the issue of credibility. It seems to fear that the slightest sign of weakness would call its inflation-fighting credentials into doubt. Policy makers at all three central banks would agree, in principle, that credibility is important. None of them want to see the emergence of long-term inflationary expectations on the part of firms and households. However, the Fed and the Bank of England are more willing to gamble on public understanding that any present departures from strict inflation targeting are driven by circumstances, and do not justify an increase in long-run inflation expectations. [Footnote: On April 7, the ECB raised its benchmark interest rate a quarter of a percentage point.]

Last, we come to the Fed. In some ways, the case for accommodation seems weaker in the United States than in the UK or the euro area. US GDP growth in the fourth quarter of 2010, at a revised 3.1%, was stronger than in the UK or the euro area, and forecasts for 2011 growth, running at 3% or better, are also higher. January and February inflation, as measured by the month-to-month increase in the headline CPI, was the most rapid of the three economies. The Fed's policy interest rate, set at a range of 0 to 0.25 percent, was the lowest of the three. Finally, as in England, the Fed had gone beyond low interest rates to engage in a vigorous program of quantitative easing.

What is more, the Fed, unlike the Bank of England, does not face the need to maintain easy monetary policy as an offset to tight fiscal policy. On the contrary, US fiscal policy, especially after December's new round of tax cuts, remains strongly expansionary. Neither the administration's budget, nor any actions taken to date by Congress, come close to dealing seriously with a budget deficit that continues at record levels.

Yet, despite these circumstances, the Fed seems least likely of any of the big three central banks to tighten its policy in response to rising oil prices. As in the case of the ECB, both legal and attitudinal factors come into play. Unlike the ECB, the Fed, by law, is tasked with balancing price stability against the need to fight unemployment, which remains very high. Also, the Fed, more than other central banks, focuses on core inflation, and on measures of expected inflation, neither of which is rising as rapidly than the headline CPI.

Unless some strong indications of higher inflation emerge, for example, a sharp increase in long-term interest rates, it seems almost certain that the Fed will keep interest rates low and carry its current program of quantitative easing through to its scheduled completion in June. At that point, if oil prices are still on an upward trajectory, if Congress has still done nothing about the deficit, and if there are signs that headline price increases are spilling through into core inflation and indicators of expectations, a turn to a less accommodative policy becomes likely.

Follow this link to view or download a short slideshow on accommodation of price shocks. The slideshow incorporates simple macroeconomic analysis.