The Oil Shock and Monetary Policy

The impact of the oil price decline on OECD economies is clouded by how central banks are responding to the fall. Usually, the prescription for oil-importing advanced economies is to focus on underlying inflation (core inflation) and look through the temporary impact of lower energy prices on headline inflation.

Under such circumstances, the central bank would assess the competing impacts of stronger demand from the lower oil prices against potentially lower core inflation reflecting pass-through and knock-on impacts from the drop in energy prices. Whether this would involve higher or lower interest rates is typically a case-by-case, country-by-country judgement.

But we are not in normal times for much of the global economy. Excess capacity remains rampant, interest rates are near zero in many major economies, inflation is well below target and unusually low inflation expectations are showing signs of becoming entrenched.

Against this backdrop, central banks are right to focus on doing everything possible to ensure modest, non-threatening levels of inflation are features of economies and to fight deflationary impulses. Consequently, we have seen many central banks move to lower interest rates over the past few months.

Simulations conducted with QIC’s proprietary version of the NiGEM global economic model suggest that the oil price shock will lead inflation in the OECD economies to be around two  percentage points (ppts) lower in 2015 than was originally forecast before the recent 50 per cent fall in the oil price.

Currency fears

Without the announcement of the European Central Bank’s (ECB) quantitative easing (QE) package, consumer prices in Europe were set to fall one per cent in 2015 and struggle to return to positive territory in 2016, risking the anchoring of unusually low inflation expectations.

However, accompanying the surge of liquidity associated with the ECB’s QE programme is a weaker euro and fears of currency wars. Every country is fearful that a rising currency will compound the impact on inflation from the drop in oil prices.

In the case of the US, our modelling suggests that if the US Federal Reserve (Fed) keeps on-track to start gradually raising rates around Q2/Q3, then the impact of the higher US dollar and lower oil price will push US inflation down by around 2.5ppts in 2015, with US inflation set to drop to around -0.5 per cent by mid-year, similar to levels seen in Europe.

The question is ‘Will the Fed start to waver and shift course?’ If the Fed becomes concerned that low headline inflation may destabilise long-run inflation expectations, then our modelling suggests that the Fed could delay rate hikes by around a year (Figure 1). That will help contain the appreciation of the dollar and boost inflation during 2015.

But at what cost? The stronger demand from the lower oil prices is expected to push unemployment rates down towards five per cent. Real consumer wages are set to grow strongly, and if the Fed delays by a year, we’d expect to see inflation return quickly towards its target in 2016.

With the Fed falling behind the curve, it would be forced to raise the US federal funds rate by 150-200bps within a year, risking another taper tantrum and the associated global market turmoil of 2013.

Alternatively, if the Fed decides to “look through” or exclude the impact of lower oil prices on the inflation outlook over the next two years, our modelling suggests that the Fed would begin raising rates during the September quarter. Hence, with the lower oil prices pushing growth up close to four per cent and eroding the excess capacity in the labour market, a forward-looking Fed favouring a smooth and gradual increase in rates should stay on course and raise rates this year.

Implications for Australia

Without a policy response by the Reserve Bank of Australia (RBA), our simulations suggest that lower oil prices would lead to a drop in inflation to around 0.5 per cent by mid-year, well outside the RBA’s 2-3 per cent target band. The exchange rate would appreciate to above US$0.80, constraining the economic recovery.

Under such a scenario the impact of the lower oil prices would no longer be a near-term positive for the Australian economy. This, in our view, is one of the reasons for the RBA’s February rate cut.

If the Fed were to delay tightening to next year, our modelling suggests that the RBA could justify cutting rates by a further 100bps to 1.25 per cent to offset pressure on the exchange rate, promote recovery in economic growth and boost inflation back to the target band (Figure 2).

Such an action would risk promoting instability in both financial markets and further fuel the housing market. If on the other hand, the Fed raises rates in the September quarter, our simulations suggest the RBA should cut rates to two per cent with a 40 per cent probability that rates would need to be lowered to 1.75 per cent.

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